Problem 2 - Accounting

Question

International Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of \(\$ 85,000\), with a \(\$ 5,000\) residual value and a 10 -year life. The equipment will replace one employee who has an average wage of \(\$ 23,000\) per year. In addition, the equipment will have operating and energy costs of \(\$ 6,000\) per year. Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment.

Step-by-Step Solution

Answer

The average rate of return on the equipment is 10.59\%.

Step 1: Calculate Annual Depreciation

The annual depreciation is calculated using the straight-line method. We start with the formula for straight-line depreciation: \[ \text{Annual Depreciation} = \frac{\text{Cost of Equipment} - \text{Residual Value}}{\text{Useful Life}} \] Substituting the given values: \[ \text{Annual Depreciation} = \frac{85,000 - 5,000}{10} = 8,000 \] Therefore, the annual depreciation is \$8,000.

Step 2: Determine Annual Net Savings

Calculate the annual net savings from replacing the employee. The employee's annual wage savings minus the operating and energy costs gives us the net savings: \[ \text{Net Savings} = \text{Employee's Wage} - \text{Operating and Energy Costs} \] Substituting the given values: \[ \text{Net Savings} = 23,000 - 6,000 = 17,000 \] Hence, the annual net savings is \$17,000.

Step 3: Calculate Average Annual Income

The average annual income from the investment is the net savings minus the annual depreciation: \[ \text{Average Annual Income} = \text{Net Savings} - \text{Annual Depreciation} \] Substituting the calculated values: \[ \text{Average Annual Income} = 17,000 - 8,000 = 9,000 \] Thus, the average annual income is \$9,000.

Step 4: Compute Average Rate of Return

The average rate of return is the average annual income divided by the initial investment cost, express it in percentage: \[ \text{Average Rate of Return} = \left( \frac{\text{Average Annual Income}}{\text{Cost of Equipment}} \right) \times 100\% \] Substituting the values: \[ \text{Average Rate of Return} = \left( \frac{9,000}{85,000} \right) \times 100\% = 10.59\% \] Therefore, the average rate of return on the equipment is 10.59\%.

Key Concepts

Understanding Straight-Line Depreciation

When businesses acquire new equipment, understanding how its cost is allocated over time is crucial. Straight-line depreciation is a method to calculate an annual expense, which represents the gradual decrease in value of an asset. This method assumes that the asset provides equal value throughout its useful life.

Here's how you can calculate it:

• First, ascertain the initial cost of the equipment and its residual value or salvage value at the end of its useful life.
• Deduct the residual value from the purchase price to determine the total amount to be depreciated.
• Then, divide this value by the number of years you expect to use the equipment.

The formula for straight-line depreciation is: \[ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} \]

This method is favored for its simplicity and is a staple in many accounting practices to evenly spread the expense over the asset's life.

Capital Investment Analysis: Evaluating Profits

Capital investment analysis is the method businesses use to scrutinize potential investments or expenditures. This is essential in deciding whether or not the investment will bring in adequate returns compared to the cost.

In the context of equipment, such as the scenario with International Fabricators Inc.,

• Identify and estimate all potential savings and costs.
• Determine the operational savings, like replacing labor costs with machinery.
• Consider maintenance and operation costs of the new equipment.

By subtracting any new associated costs from the savings garnered by the equipment, you can assess your net gain or net savings before depreciation.

Capital investment analysis ensures you are making informed decisions about major purchases and helps anticipate the long-term financial impacts on your business.

Evaluating Equipment Investment

Investing in equipment requires careful consideration of multiple factors. It’s not just about the price tag but also evaluating the potential return on investment (ROI) and overall value added to the business.

To effectively evaluate an equipment investment:

• Calculate the average rate of return, which compares the annual earnings produced by the investment against its initial cost.
• Understand both the cost savings from reduced labor and the expenses due to equipment operation.
• Project how this new equipment will fit into your operations and its potential benefits.

In our example, the rate of return calculation helped determine a 10.59% return, indicating a healthy benefit from purchasing the equipment.

Smart equipment investments can provide significant competitive advantages, making the business more efficient and ultimately more profitable.