Exercise-14: Accounting rate of return (ARR) using average investment

Learning objective:
This exercise illustrates ARR computation using the average investment in the project rather than the initial cost as the denominator of the formula.

A stone crushing company is planning to purchase a Wheel Loader to be used for conveying raw stone to a large Stone Crushing Machine and loading crushed stone in trucks. A new Wheel loader can be purchased directly from Caterpillar company for $150,000. The new Wheel Loader will reduce the annual cost by $25,500 and increase annual operating expenses by $4,500. The useful life of the Wheel Loader is 20 years. After which, it will have a salvage value of $30,000. Company uses straight line method of depreciation for all assets.

Required: Compute accounting rate of return of wheel loader using average investment approach.

Solution:

Step 1 – Computation of depreciation:

Annual depreciation = (Cost of the asset – Salvage value)/Useful life
= ($150,000 – $30,000)/20
= $6,000

Step 2 – Computation of annual net cost saving:

Annual net cost saving = $25,500 – ($4,500 + $6,000)
= $15,000

Step 3 – Computation of average investment in asset:

Because the company uses straight line method of depreciation, the average investment can be computed by adding cost of the asset to the residual value and then dividing by 2. It is shown below:

Average investment = (Cost of the asset + Residual value)/2
= ($150,000 + $30,000)/2
= $90,000

Step 4 – Computation of accounting rate of return:

Accounting rate of return = Annual net cost saving/average investment
= $15,000/$90,000
= 16.67%

Note: In this exercise, we have used average investment as the denominator of the formula. But sometime analysts use original cost of the asset as the denominator. See exercise 9, 12 and 13.