Recap Corporation made a capital investment of $ 100,000 in new equipment 2 years ago. The analysis made at that time indicated that the equipment would save $36,400 in operating expenses per year over a 5-year period, or a 24% return on capital before taxes per year based on the internal rate of return analysis.
The department manager believed that the equipment was living up to expectations. However, the departmental report showing the overall return on investment (ROI) rate for the first year in which this equipment was used did not reflect as much improvement as had been expected. The department manager asked the accounting section to "break out" the figures related to this investment to find out why it did not contribute more to the department's ROI.
The accounting section was able to identify the equipment and its contribution to the department's operations. The report presented to the department manager at the end of the first year was as follows:
Reduced operating expenses due to new equipment $ 36,400
Less depreciation (20% of cost) 20,000
Contribution before taxes $ 16,400
Investment at beginning of year $100,000
Investment at end of year 80,000
Average investment for the year 90,000
Return on investment ($16,400 -f $90,000) 18.2%
The department manager was surprised that the ROI was less than the 24% internal rate of return, because the new equipment was performing as expected.
Required:
(1) Discuss the reasons why the 18.2% return on investment for the new equipment as calculated in the department's report by the accounting section differs from the 24% internal rate of return calculated at the time the machine was approved for purchase. (2) Explain how Recap Corporation might restructure the data from the internal rate of return analysis, so that the expected performance of the new equipment is consistent with the operating reports received by the department manager.