Q6SE - Horngren'S Financial And Managerial Accounting

Question

S26-6 Using the ARR method to make capital investment decisions Refer to the Hunter Valley Snow Park Lodge expansion project in Short Exercise S26-4. Calculate the ARR. Round to two decimal places.

Step-by-Step Solution

Answer

The accounting rate of return is 21.19%.

Step 1: Definition of Accounting Rate of Return

The accounting rate of return refers to the percentage calculated under capital budgeting using the net income generated and the initial investment made It does not take into consideration the time value of money. 

Step 2: Calculation of accounting rate of return

$\begin{array}{c}\mathrm{ARR}=\frac{\mathrm{Average} \mathrm{annual} \mathrm{operating} \mathrm{income}}{\mathrm{Average} \mathrm{amount} \mathrm{invested}}\\ =\frac{\mathrm{\$}1,229,042}{\mathrm{\$}5,800,000}\\ =21.19\mathrm{\%}\end{array}$

Working note:

$\begin{array}{c}\mathrm{Averageannualnetcashflow}=\left(\begin{array}{l}\mathrm{Number} \mathrm{of} \mathrm{additional} \mathrm{skiers}\times \mathrm{Average} \mathrm{number} \mathrm{of} \mathrm{days} \mathrm{allow} \mathrm{skiing}\times \\ \left(\mathrm{Average} \mathrm{cash} \mathrm{spent} \mathrm{by} \mathrm{skier}-\mathrm{Average} \mathrm{variable} \mathrm{cost} \mathrm{per} \mathrm{skier}\right)\end{array}\right)\\ =\left(121\times 142\left(\mathrm{\$}241-\mathrm{\$}83\right)\right)\\ =\mathrm{\$}2,714,756\end{array}$

$\begin{array}{c}\mathrm{Average}\mathrm{annual}\mathrm{operating}\mathrm{income}=\mathrm{Average}\mathrm{annual}\mathrm{net}\mathrm{cash}\mathrm{inflow}-\mathrm{Depreciation}\\ =\mathrm{\$}2,714,756-\mathrm{\$}1,485,714.29\\ =\mathrm{\$}1,229,042\end{array}$

Calculation of depreciation on a straight-line method

$\begin{array}{c}\mathrm{Depreciation}=\frac{\mathrm{Cost}-\mathrm{Residual}\mathrm{value}}{\mathrm{Year}}\\ =\frac{\mathrm{\$}11,000,000-\mathrm{\$}600,000}{7}\\ =\mathrm{\$}1,485,714\end{array}$

$\begin{array}{c}\mathrm{Average} \mathrm{amount} \mathrm{invested}=\frac{\mathrm{Amount} \mathrm{invested}+\mathrm{Residual} \mathrm{value}}{2}\\ =\frac{\mathrm{\$}11,000,000+\mathrm{\$}600,000}{2}\\ =\mathrm{\$}5,800,000\end{array}$