Blossom Oil Company is considering investing in a new oil well. It is expected that the oil well will increase annual revenues by $136,250 and will increase annual expenses by $74,000 including depreciation. The oil well will cost $404,000 and will have a $11,000 salvage value at the end of its 10-year useful life. Calculate the annual rate of return. (Round answer to 0 decimal places, e.g. 13%.)
Annual rate of return %
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The Correct Answer and Explanation is:
Correct Answer: 15%
Explanation:
To calculate the Annual Rate of Return (ARR), we use the following formula:
$$
\text{Annual Rate of Return (ARR)} = \left( \frac{\text{Average Annual Accounting Income}}{\text{Initial Investment}} \right) \times 100
$$
Step 1: Determine the Average Annual Accounting Income
Annual Revenue Increase: \$136,250
Annual Expense Increase (including depreciation): \$74,000
$$
\text{Net Annual Income} = 136,250 – 74,000 = 62,250
$$
This is the annual accounting income, which already includes depreciation. So we don’t need to make any additional adjustments for depreciation here.
Step 2: Calculate the Initial Investment
The cost of the oil well is \$404,000.
Even though the oil well has a salvage value of \$11,000, this is used when computing depreciation and does not impact the ARR directly, because ARR is based on the initial investment, not net investment.
$$
\text{Initial Investment} = 404,000
$$
Step 3: Plug into the ARR Formula
$$
\text{ARR} = \left( \frac{62,250}{404,000} \right) \times 100 = 15.4\%
$$
Rounded to 0 decimal places, the Annual Rate of Return = 15%
Understanding the Concept:
The Annual Rate of Return (ARR) is a simple method of evaluating investments that tells a company how much net income it will generate annually relative to how much it initially invested.
ARR is useful for basic comparisons between different projects, especially when management needs a quick estimate of profitability. However, it does not consider the time value of money, unlike methods like Net Present Value (NPV) or Internal Rate of Return (IRR). For long-term investments or those with variable cash flows, more advanced techniques are often preferred.
In this case, Blossom Oil Company sees a return of 15 cents for every dollar invested each year, making it a potentially attractive investment depending on the company’s required rate of return.
