Q21E - Horngren'S Financial And Managerial Accounting

Question

Using ARR to make capital investment decisions Refer to the Henry Hardware information in Exercise E26-20. Assume the project has no residual value. Compute the ARR for the investment. Round to two places.

Henry Hardware is adding a new product line that will require an investment of \(1,512,000. Managers estimate that this investment will have a 10-year life and generate net cash inflows of \)310,000 the first year, \(270,000 the second year, and \)240,000 each year thereafter for eight years.

Step-by-Step Solution

Answer

ARR is 13.07%

Step 1: Meaning of ARR

ARR depicts the effect of the investment on the company's accrual-based income. The accounting rate of return could be a proportion that does not consider the thought of time worth of cash.

Step 2: Computing the ARR for the investment

$\begin{array}{rcl}Total net cash inflows suring operating life of project& =& Sum of net cash inflows during operating life of project\\ & =& \$310,000Yr.1+\$270,000Yr.2+(240,000\times 8yrs.)\\ & =& \$2.500,000\end{array}$

$\begin{array}{rcl}Total depreciation during operating life of project& =& Cost-Residual value\\ & =& \$1,512,000-\$0\\ & =& \$1,512,000\end{array}$

Average annual operating income

Total net cash inflows during the operating life of the project	$2,500,000
Less: Total depreciation during the operating life of the project	1,512,000
Total operating income during the operating life	988,000
Divide by: Project’s operating life in years	10 years
Average annual operating income from the project	$ 98,800

$\begin{array}{rcl}Average amount invested& =& \frac{Amount invested+Residual value}{2}\\ & =& \frac{\$1,512,000+\$0}{2}\\ & =& \$756,000\end{array}$

$\begin{array}{rcl}ARR& =& \frac{Average annual operation Income}{Average amount invested}\\ & =& \frac{\$98,800}{\$756,000}\\ & =& 13.07\%\left(rounded\right)\end{array}$