Average Rate of Return—New Product Galactic Inc. is considering an investment in

ID: 2474188 • Letter: A

Question

Average Rate of Return—New Product Galactic Inc. is considering an investment in new equipment that will be used to manufacture a smartphone. The phone is expected to generate additional annual sales of 6,000 units at $250 per unit. The equipment has a cost of $850,000, residual value of $50,000, and an eight-year life. The equipment can only be used to manufacture the phone. The cost to manufacture the phone follows: Cost per unit: Direct labor $ 15.00 Direct materials 134.00 Factory overhead (including depreciation) 33.50 Total cost per unit $182.50 Determine the average rate of return on the equipment. If required, round to the nearest whole percent. %

- ANSWER IS NOT 48%

Explanation / Answer

Solution:

Calculation of Annual Net Profit after depreciation and taxes

Sales Revenue

$1,500,000

Expenses:

Direct Labor

$90,000

Direct Material

$804,000

Factory Overhead (including depreciation)

$201,000

Total Cost

$1,095,000

Profit

$405,000

The accounting rate of return is also known as the Average rate of return. ARR is a financial ratio used in capital budgeting. ARR does not take into account the concept of time value of money. ARR measures the average annual net income of the project in % term of proposed investment.

Average Rate of Return = Average Annual Net Income after depreciation and taxes / Average Investment

= $405,000 / $450,000 x 100 = 90%

Average Investment = ½ (Initial Investment + Scrap Value) = ½ ($850,000 + $50,000) = $450,000

Average Rate of Return can also be calculated by using following formula:

Note ---- Average Rate of return = Avarage Annual Net INcome after depreciation and taxes / Initial Investment x 100, then you will get the answer as follows:

ARR = $405,000 / $850,000 x 100 = 47.65%