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22 September, 17:04

Average Rate of Return Lakeland Company is considering the purchase of equipment for $175,000. The equipment will expand the Company's production and increase revenue by $40,000 per year. Annual cash operating expenses will increase by $12,000. The equipment's useful life is 10 years with no salvage value. Lakeland uses straight-line depreciation. The income tax rate is 25%. What is the average rate of return on the investment

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  1. 22 September, 19:16
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    The Average rate of return on investment is 5%

    Explanation:

    Solution

    Given that:

    Increase in revenue = $ 40,000.00

    Increase in expenses $ 29,500.00

    Pretax income from investment = $ 10,500.00

    Income tax expense=$ 2,625.00

    Net income from investment = $ 7,875.00

    Now,

    The Average rate of return on investment = (Net income from investment / Initial Investment) * 100

    = ($7875 / $ 1,75,000) * 100

    = 4.5 %

    = 5 % (Rounded off to nearest whole number)

    Thus, Average rate of return on investment is 5%

    Working Note:

    The Increase in expenses is calculated as follows:

    The Increase in expenses = Annual cash operating expenses + Depreciation

    = $ 12,000 + $ 17,500

    = $ 29,500

    Thus,

    The Depreciation is computed by applying the Straight-line method as follows:

    The Depreciation = (Purchase cost - Salvage value) / useful life

    = ($ 1,75,000 - 0) / 10

    = $ 17,500 per year

    Thus,

    The Depreciation is non - cash expenditure hence it is considered while determining the profitability of company.

    The Calculation of Income tax expense as follows:

    The Income expense tax = Pretax income from investment * Income tax rate

    = $ 10,500 * 25%

    = $ 2,625
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