Exercise-12: Accounting or simple rate of return method with salvage value

Learning objective:
This exercise illustrates the accounting or simple rate of return when a salvage value is given

A proposal to purchase a new machine is being considered by the management of  HiTech manufacturing company. The new machine would increase production and revenues. HiTech uses accounting rate of return method to evaluate capital investments like this. The relevant data is given below:

• Cost of new machine: $1,200,000
• Useful life of the machine: 10 years
• Expected annual cash inflows associated with the new machine: $450,000
• Operating expenses associated with the new machine: $26,000
• Salvage value of the machine at the end of 10-year period: $80,000

The expected annual cash inflows given above is the only revenue that the new machine will generate. The operating expenses of $26,000 given above do not include the annual depreciation of the machine. HiTech company uses a traditional straight-line method of depreciation to depreciate all of its plant assets.

Required:

1. Compute accounting/simple rate of return of the machine.
2. Would HiTec company purchase the machine if its desired accounting/simple rate of return is 20%?

Solution:

 (1) Accounting or simple rate of return:

In order to compute the accounting rate of return, we need to find the incremental operating income associated with the new machine.

Incremental operating income per year = $450,000 – ($26,000 exp. + $112,000 dep.*)
= $312,000

*($1,200,000 Cost – $80,000 Salvage value)/10 years
= $1,120,000/10 years
= $112,000

Now that we have computed the incremental operating income, we can obtain the machine’s accounting rate of return by simply dividing it by the initial investment.

Accounting/simple rate of return = Incremental accounting income/Initial investment
= $312,000/$1,200,000
= 26%

(2) Decision of the management:

Management should purchase the new machine because it promises a 26% accounting or simple rate of return that is higher than the management’s desired rate of return.