Question

An investment has an initial cost of $2.7 million and net income of $189,400, $178,600, and $172,500 for Years 1 to 3. The average book value is $1.35 million. Should this project be accepted based on the average accounting rate of return if the required rate is 12.5 percent? Why or why not?
a. Yes, because the AAR is 12.5 percent
b. Yes, because the AAR is less than 12.5 percent
c. Yes, because the AAR is greater than 12.5 percent
d. No, because the AAR is greater than 12.5 percent
e. No, because the AAR is less than 12.5 percent

Answer 1

Answer: c. Yes, because the AAR is greater than 12.5 percent

Explanation:

Average Accounting rate of return = Average Net Income / Average Assets

Average Net income = (189,400 + 178,600 + 172,000) / 3 years

= $180,166.66667

Average Assets = 2,700,000 / 3 years

= $900,000

Average Account rate of return = 180,166.66667/ 900,000

= 20.01%

The AAR at 20.01% is greater than the required rate which is 12.5% so the project should be accepted.