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:
Annual Rate of Return Calculation
To calculate the Annual Rate of Return (ARR), we use the following formula: Annual Rate of Return (ARR)=(Average Annual Accounting IncomeInitial Investment)×100\text{Annual Rate of Return (ARR)} = \left( \frac{\text{Average Annual Accounting Income}}{\text{Initial Investment}} \right) \times 100
Step 1: Calculate Annual Accounting Income
Annual Accounting Income=Annual Revenue−Annual Expenses\text{Annual Accounting Income} = \text{Annual Revenue} – \text{Annual Expenses} =136,250−74,000=62,250= 136,250 – 74,000 = 62,250
Step 2: Determine the Initial Investment
Initial Investment=404,000\text{Initial Investment} = 404,000
Note: We use the initial investment amount without subtracting the salvage value.
Step 3: Calculate ARR
ARR=(62,250404,000)×100≈15.4%\text{ARR} = \left( \frac{62,250}{404,000} \right) \times 100 \approx 15.4\%
Rounding to 0 decimal places, as instructed: 15%\boxed{15\%}
Explanation
The Annual Rate of Return (ARR) is a widely used metric in capital budgeting that helps evaluate the profitability of an investment. It represents the expected return on an investment expressed as a percentage of the initial cost. In this case, Blossom Oil Company is assessing the feasibility of investing in a new oil well.
First, the project is expected to generate an increase in annual revenue of $136,250. However, it will also lead to higher annual expenses of $74,000, which includes depreciation. Subtracting the expenses from the revenues gives us the annual accounting income, which is $62,250.
The ARR formula compares this average annual accounting income to the total cost of the investment. Blossom Oil plans to invest $404,000 in the new oil well. Although the well will have a salvage value of $11,000 at the end of its 10-year life, this value is not used in the ARR calculation because ARR focuses on accounting income, not cash flows or net present value.
By dividing the annual income of $62,250 by the initial investment of $404,000 and multiplying by 100, we calculate an ARR of approximately 15.4%. When rounded to the nearest whole number, this results in an annual rate of return of 15%.
This percentage can be used by Blossom Oil Company to compare this investment opportunity to others or to a required rate of return set by company policy. If 15% exceeds their target return, the investment may be considered favorable.
Final Answer: 15%\boxed{15\%}
