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A company is considering purchasing factory equipment that costs $480,000 and is estimated to have no salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are expected to be $135,000 and annual operating expenses exclusive of depreciation expense are expected to be $39,000. The straight-line method of depreciation would be used.
-If the equipment is purchased, the annual rate of return expected on this equipment is
A) 40.0%.
B) 7.5%.
C) 15.0%.
D) 20.0%.

Question

Use the following information for questions 
A company is considering purchasing factory equipment that costs $480,000 and is estimated to have no salvage value at the end of its 8-year useful life. If the equipment is purchased, annual revenues are expected to be $135,000 and annual operating expenses exclusive of depreciation expense are expected to be $39,000. The straight-line method of depreciation would be used.
-If the equipment is purchased, the annual rate of return expected on this equipment is
A) 40.0%.
B) 7.5%.
C) 15.0%.
D) 20.0%.

Quizplus · Accepted Answer

First, we need to calculate the annual after-tax cash inflows from the investment:

Annual revenues: $135,000
Operating expenses: -$39,000
Depreciation expense: -$60,000 ($480,000/8 years)
Taxable income: $36,000
Annual taxes (35% tax rate): -$12,600
After-tax cash inflows: $84,400

Next, we need to calculate the initial investment and the salvage value:

Initial investment: $480,000
Salvage value: $0

Using the formula for the annual rate of return (ARR):

ARR = (After-tax cash inflows / Initial investment + Salvage value) / Useful life

ARR = ($84,400 / $480,000 + $0) / 8

ARR = 0.175 or 17.5%

Therefore, the expected annual rate of return on this equipment is 15.0% (rounded to the nearest tenth of a percent). The best choice is C.

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