Ennis Ltd is considering the purchase of a machine to produce a new product. The machine will cost the business £450,000 and has an expected life of five years. Annual operating profits from the machine are expected to be as follows
The new machine will be depreciated using the straight-line method and the estimated disposal value at the end of its useful life is £70,000.
The business has a target accounting rate of return of 25% for new investment projects.
a) Calculate the accounting rate of return for the new machine.
b) Should the machine be purchased?
Operating profits
£
Year 1 58,000
Year 2 82,000
Year 3 69,000
Year 4 38,000
Year 5 28,000
a) Accounting rate of return = Average Net profits / Average New investment
= -21000/ 225000
= - 9.33%
b) No machine should not be purchased as the accounting rate of return is -9.33% against business target rate of return of 25%
Notes :-
Average annual cash inflow = £ (58000 + 82000 + 69000 + 38000 + 28000) / 5
= £ 55000
Annual depreciation expense = £ (450000 - 70000) / 5
= £ 76000
Average net profits = Average annual cash inflow - Annual Depreciation
= £ (55000 - 76000)
= - £ 21000
Average new investment = £ (450000 + 0) / 2
= £ 225000
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Anonymous posted 4 months ago
wrong answer as teacher already gave operating profits, so we dont need to adjust depreciation