Application: A Letter to the Board of Directors

WMBA 6050: Accounting for Management Decision Making

Accounting Rate of Return/Return on Investment (ROI)

A company invested $10,000,000 in a project that has a 10-year life and no salvage value. The

expected operating income is $4,000,000 in each of the next ten years, and the tax rate is 40%.

The steps to determine the ROI are as follows:

1. Compute net income

Operating income $4,000,000

Depreciation 1,000,000 ($10,000,000/10-year life)

Net income before taxes 3,000,000

Taxes (40%) 1,200,000 ($3,000,000 x .40)

Net income $1,800,000

2. Compute average net income and average book value of the investment

Calculate the average book value of the investment by taking the beginning book value, adding

the ending book value, and dividing by 2. The ending book value each year is the beginning

book value for the year less the depreciation for the year.

Year Net

Income

Average Book Value

of Investment

1 1,800,000

9,500,000 (10,000,000 + 9,000,000)/2

2 1,800,000

8,500,000 (9,000,000 + 8,000,000)/2

3 1,800,000

7,500,000 (8,000,000 + 7,000,000)/2

4 1,800,000

6,500,000 (7,000,000 + 6,000,000)/2

5 1,800,000

5,500,000 (6,000,000 + 5,000,000)/2

6 1,800,000

4,500,000 (5,000,000 + 4,000,000)/2

7 1,800,000

3,500,000 (4,000,000 + 3,000,000)/2

8 1,800,000

2,500,000 (3,000,000 + 2,000,000)/2

9 1,800,000

1,500,000 (2,000,000 + 1,000,000)/2

10 1,800,000 500,000 (1,000,000 + 0)/2

Average 1,800,000

5,000,000 (An easy way to find the average book value of

The investment is to divide the investment by 2.)

3. Compute ROI

Average annual income from project = 1,800,000 = 36%

Average annual investment in the project 5,000,000