Question 19.3: The accounting rate of return method Bridge Limited is consi...
The accounting rate of return method
Bridge Limited is considering investing in a new project, the details of which are as follows:
| Project life | 5 years | |
| £000 | £000 | |
| project cost | 50 | |
| Estimated net profit: | ||
| Year 1 | 12 | |
| 2 | 18 | |
| 3 | 30 | |
| 4 | 25 | |
| 5 | \underline{5} | |
| Total net profit | \underline{\underline{90} } | |
The estimated residual value of the project at the end of Year 5 is £10,000.
Required:
Calculate the accounting rate of return of the proposed new project using:
(a) the original capital employed
(b) the average capital employed.
The accounting rate of return would be calculated as follows:
(a) Using the initial capital employed:
\frac{Average annual net profits}{Cost of the investment} \times 100
Average annual net profits = £18 000 (£90 000/5)
∴ Accounting rate of return = \frac{£18 000}{50 000} \times 100=\underline{36\%}
(b) Using the average capital employed:
\frac{Average annual net profits}{Average capital employed} \times 100
=\frac{£18 000}{\frac{1}{2} \left(£50 000+ 10 000\right) }\times 100 =\underline{60\%}