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

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