Question from Wiley:
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment's estimated useful life is ten years, with no residual value, and it would be depreciated by the straight-line method. Tam's predetermined minimum desired rate of return is 12%. The present value of an annuity of 1 at 12% for ten periods is 5.65. The present value of 1 due in ten periods at 12% is .322. Accrual accounting rate of return based on the initial investment is
30%
20%
12%
10%
answer: (d) The accounting rate of return (ARR) computes an approximate rate of return which ignores the time value of money. It is calculated as Expected increase in annual net income ¡Â Initial (or Average) investment in a project. Tam's expected increase in annual income is as follows:
Annual savings in after-tax cash costs $20,000
Annual depreciation on equipment ($100,000 ¡Â 10 years) (10,000)
Increase in annual net income $10,000
I do not understand why the depreciation is not consider the tax effect, since the cost saving is “after tax cash cost” ? Any suggestions will be much appreciated.
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