1102AFE Accounting for Decision Making

1102AFE ACCOUNTING FOR DECISION MAKING
Trimester 3, 2019
Assessable Homework 9
TOTAL MARKS = 30 marks—divide by 10 to get a % out of 3%
Situation:
You are deciding to start a delivery business in January 2020. The initial investment
includes a small truck which costs $70,000. Other expenses were included in the
expected cash flows. The truck has a useful life of 5 years and an estimated residual
value at the end of the 5th year of $10,000 (the amount expected the truck can be
sold). Depreciation is the only non-cash expense.
The net cash flows of each year in the following 5 years are estimated as follows:
Initial investment: $70,000
Net cash flow year 1: (20,000)
Net cash flow year 2: 10,000
Net cash flow year 3: 20,000
Net cash flow year 4: 40,000
Net cash flow year 5: 30,000
Estimated sale of truck year 5: 10,000
Question 1: (10 marks)
If your required rate of return is 8%, what would be your decision based on the
accounting rate of return (ARR)?
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1102AFE ACCOUNTING FOR DECISION MAKING
Trimester 3, 2019
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Total Depreciation =( Initial Investment- Sale Value)
($70000-$10000)=$60000
Average Profit =(Sum of Cash Flow-Depreciation)/ No of years
((-20000+10000+20000+40000+30000)-60000)/5=$4000
Average investment = ( Initial Value+ End Value)/2
(70000+10000)/2
ARR = Average Profit/ Average Investment
= 4000/40000
=10%
Decision? Why?
The project should be accepted when compared with the required rate of return.
This is because the accounting rate of return of the project is 10%, while the
required rate of return is 8%. Thus since the accounting rate of return than
the required rate of return, the project will generate value for the company
and is attractive for the company.
The greater the accounting rate of return from the required rate of return,
the more attractive is the project for the company.