Question 4.2: Chaotic Industries is considering an investment in a fleet o...
Chaotic Industries is considering an investment in a fleet of ten delivery vans to take its products to customers. The vans will cost £15,000 each to buy, payable immediately. The annual running costs are expected to total £50,000 for each van (including the driver’s salary). The vans are expected to operate successfully for six years, at the end of which period they will all have to be sold, with disposal proceeds expected to be about £3,000 a van. At present, the business outsources transport, for all of its deliveries, to a commercial carrier. It is expected that this carrier will charge a total of £530,000 each year for the next six years to undertake the deliveries.
What is the ARR of buying the vans? (Note that cost savings are as relevant a bene-fit from an investment as are net cash inflows.)
The vans will save the business £30,000 a year (that is, £530,000 − (£50,000 × 10)), before depreciation, in total. Thus, the inflows and outflows will be:
| Time | £000 | |
| Immediately | Cost of vans (10 × £15,000) | (150) |
| 1 year’s time | Saving before depreciation | 30 |
| 2 year’s time | Saving before depreciation | 30 |
| 3 year’s time | Saving before depreciation | 30 |
| 4 year’s time | Saving before depreciation | 30 |
| 5 year’s time | Saving before depreciation | 30 |
| 6 year’s time | Saving before depreciation | 30 |
| 6 year’s time | Disposal proceeds from the vans (10 × £3,000) | 30 |
The total annual depreciation expense (assuming a straight-line method) will be £20,000 (that is, (£150,000 − £30,000)/6). Thus, the average annual saving, after depreciation, is £10,000 (that is, £30,000 − £20,000).
The average investment will be
Average investment =\frac{ £150,000 + £30,00}{2}
= £90,000
and the ARR of the investment is
ARR =\frac{£10,000}{£90,000}× 100\%
= 11.1%