- 20 Marks
Question
Steady Ltd wants to buy a new item of equipment which will be used to provide better services to the customers of the company. Two models of equipment are available, one with a slightly higher capacity and greater reliability than the other. The expected costs and profits of each equipment are as follows:
Equipment SPED XPRS Capital Cost N800,000 N1,500,000 Life span 5 years 5 years Profits before depreciation N N Year 1 600,000 600,000 Year 2 500,000 600,000 Year 3 400,000 500,000 Year 4 300,000 500,000 Year 5 200,000 300,000 Disposal value 50,000 0
The company‟s target ARR is 30%. Which of the TWO equipment should be selected, if any?
Answer
Equipment SPED should be selected. It gives a higher ARR at 58.82%, which is more than the company’s target ARR of 30%.
Workings
Accounting Rate of Returns
ARR = Estimated average profit x 100% Estimated average investment
Where:
Average annual Profit = Total profit after depreciation Number of years of the project
Average Investment = initial investment + disposable value 2
Annual Depreciation = initial investment – disposable value Number of useful years
Total depreciation = initial investment – disposable value
Total profits before depreciation (SPED) = N{600,000+500,000+400,000+300,000+200,000}= N2,000,000
Total profits before depreciation (XPRS) = N{600,000+600,000+500,000+500,000+300,000}= N2,500,000
Total depreciation (SPED) = Initial Investment – Disposable value = N800,000- N50,000 = N750,000
| SPED | XPRS | |
|---|---|---|
| N | N | |
| Total profits before depreciation | 2,000,000 | 2,500,000 |
| Total depreciation | (750,000) | (1,500,000) |
| Total profits after depreciation | 1,250,000 | 1,000,000 |
| Average profits (5 years) | 250,000 | 200,000 |
| Value of investment at the beginning | 800,000 | 1,500,000 |
| Value of investment at the end i.e. scrap value | 50,000 | 0 |
| Average value of investment | 425,000 | 750,000 |
| ARR | 58.82% | 26.67% |
- Tags: ARR, Average Rate of Return, Capital Budgeting, Equipment Selection, Investment Appraisal
- Level: Level 1
- Topic: Investment Decisions
- Series: MAY 2025
- Uploader: Samuel Duah