Problem 2 - Accounting

Question

General Bearings Company is considering an investment in equipment that will replace direct labor. The equipment has a cost of \(\$ 94,000\), with a \(\$ 6,000\) residual value and an 8-year life. The equipment will replace one employee who has an average wage of \(\$ 26,000\) per year. In addition, the equipment will have operating and energy costs of \(\$ 8,250\) per year. Determine the average rate of return on the equipment, giving effect to straightline depreciation on the investment.

Step-by-Step Solution

Answer

The average rate of return on the equipment is approximately 7.18%.

Step 1: Calculate Annual Depreciation

First, we need to calculate the annual depreciation of the equipment using the straight-line method. The formula for calculating annual depreciation is: \[ \text{Annual Depreciation} = \frac{\text{Cost of Equipment} - \text{Residual Value}}{\text{Useful Life}} \] Substituting the given values, \[ \text{Annual Depreciation} = \frac{94000 - 6000}{8} = \$11,000 \]

Step 2: Calculate Total Annual Savings

Next, we calculate the total annual savings by considering the wages saved and subtracting the operating and energy costs. The formula is: \[ \text{Total Annual Savings} = \text{Wages Saved} - \text{Operating and Energy Costs} \] Substituting the given values, \[ \text{Total Annual Savings} = 26000 - 8250 = \$17,750 \]

Step 3: Calculate Average Annual Profit

The average annual profit can be determined by subtracting the annual depreciation from the total annual savings. This gives us: \[ \text{Average Annual Profit} = \text{Total Annual Savings} - \text{Annual Depreciation} \] \[ \text{Average Annual Profit} = 17750 - 11000 = \$6,750 \]

Step 4: Calculate Average Rate of Return

Finally, calculate the average rate of return on the equipment using the formula: \[ \text{Average Rate of Return} = \left( \frac{\text{Average Annual Profit}}{\text{Initial Investment}} \right) \times 100 \% \] \[ \text{Average Rate of Return} = \left( \frac{6750}{94000} \right) \times 100 \% \approx 7.18\% \]

Key Concepts

Depreciation Calculation

Depreciation is a key concept in accounting that helps businesses account for the cost of an asset over its useful life. In this context, it relates to how the General Bearings Company can distribute the cost of a new piece of equipment across its anticipated usage period. Using the straight-line depreciation method, we calculate the annual depreciation by subtracting the residual value from the initial cost of the equipment and then dividing by the useful life of the asset. The formula is as follows:\[ \text{Annual Depreciation} = \frac{\text{Cost of Equipment} - \text{Residual Value}}{\text{Useful Life}} \]For General Bearings Company:- **Cost of Equipment**: \(94,000- **Residual Value**: \)6,000- **Useful Life**: 8 yearsUsing the formula, we find:\[ \text{Annual Depreciation} = \frac{94000 - 6000}{8} = \\(11,000 \]Thus, the equipment loses \)11,000 in value each year as it is used, which is a systematic allocation of the cost to the benefiting periods in the future.

Investment Analysis

Investment analysis involves evaluating the potential financial benefits of investing in an asset or project. For General Bearings Company, this analysis hinges on comparing the costs and expected savings of acquiring new equipment. First, the initial investment, which is the cost of purchasing the equipment, is $94,000. Next, the equipment is expected to save money by replacing the necessity for direct labor, generating savings from reduced wages. However, this must be offset against the annual operating and energy costs of $8,250. Such analysis allows us to assess whether the investment leads to positive cash flows and if it justifies the upfront expenditure. It's crucial to not only consider the savings versus costs but also how these balance out over the equipment's lifetime. For General Bearings Company, examining both the immediate and longer-term financial implications is vital for making informed investment decisions.

Average Rate of Return

The average rate of return (ARR) is a crucial metric for evaluating the profitability of an investment. It helps in understanding how much net profit or loss an investment is generating compared to its original cost. This measure is particularly useful for comparing different investment opportunities.Here's how we determine ARR for General Bearings Company's equipment:1. **Calculate Average Annual Profit**: Subtract the annual depreciation from the total annual savings. In this exercise, it was calculated as \(6,750.2. **Calculate ARR**: Divide the average annual profit by the initial investment cost and multiply by 100 to get a percentage:\[ \text{Average Rate of Return} = \left( \frac{6750}{94000} \right) \times 100 \% \approx 7.18\% \]An ARR of 7.18% indicates that, on average, the equipment returns \)7.18 in profit per $100 invested each year. While useful, ARR should be considered alongside other financial metrics for a more comprehensive investment appraisal.

Cost Savings Evaluation

Evaluating cost savings is a vital part of investment analysis, helping businesses determine the financial benefits of new equipment relative to its costs. General Bearings Company aims to save on labor costs by investing in new machinery. The cost savings are calculated by comparing the wages saved by replacing an employee (earning \(26,000 annually) with the new equipment's operating and energy costs (\)8,250 annually). Calculating the total annual savings involves:- **Wages Saved**: \(26,000- **Operating and Energy Costs Subtracted**: \)8,250Thus, the total annual savings are:\[ \text{Total Annual Savings} = 26000 - 8250 = \$17,750 \]This figure shows how much the company saves each year by eliminating the labor costs but incurring some operational costs. Evaluating these savings helps decision-makers understand the direct financial benefits and potential increase in overall efficiency.