An investment has an initial cost of $3.2 million. This investment will be depreciated by $900,000 a year over the 3-year life of the project. Should this project be accepted based on the average accounting rate of return if the required rate is 10.5 percent? Why or why not?
A) Yes; because the AAR is 10.5 percent
B) Yes; because the AAR is less than 10.5 percent
C) Yes; because the AAR is greater than 10.5 percent
D) No; because the AAR is greater than 10.5 percent
E) No; because the AAR is less than 10.5 percent

Question

An investment has an initial cost of $3.2 million. This investment will be depreciated by $900,000 a year over the 3-year life of the project. Should this project be accepted based on the average accounting rate of return if the required rate is 10.5 percent? Why or why not? 
A) Yes; because the AAR is 10.5 percent 
B) Yes; because the AAR is less than 10.5 percent 
C) Yes; because the AAR is greater than 10.5 percent 
D) No; because the AAR is greater than 10.5 percent 
E) No; because the AAR is less than 10.5 percent

Quizplus · Accepted Answer

The average accounting rate of return (AAR) is calculated by dividing the average annual income by the initial investment. In this case, the average annual income is the total depreciation over the 3-year life of the project, which is $900,000 * 3 = $2.7 million. Therefore, the AAR is $2.7 million / $3.2 million = 0.84375 or 84.375%. Since the required rate of return is 10.5%, the AAR is less than the required rate, indicating that the project should be rejected. Therefore, the correct answer is E.

An Investment Has an Initial Cost of $3