# Capital Budgeting Unit 3 Part 2

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## Capital BudgetingUnit 3 Part 2

Financial Management Rashid Usman Ansari Reference

Financial Management Khan & Jain

6th Edition

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###  The most common definition is as follows:

ARR=(Average Annual Profits After Tax/Average Investment over the Life of the Project) x 100

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### Continued

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Particulars Machine A Machine B

Cost Rs. 56,125 Rs. 56,125

Annual Estimated

Income After Dep. and Tax (Dep. Is Charged on the Straight Line Basis)

Year 1 3,375 11,375

2 5,375 9,375

3 7,375 7,375

4 9,375 5,375

5 11,375 3,375

Total 36,875 36,875

Estimated Life ( years ) 5 5

Estimated Salvage value 3,000 3,000

### ARR

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Average Income of Both Machines

= (36,875/5) = Rs. 7,375 Average Investment

= Salvage Value + ½ (Cost of Machine- Salvage Value)

= 3,000 + ½ ( 56,125 – 3,000)

= Rs. 29,562.50 Now,

ARR= 7,375/29,562.5 = 24.9%

ARR of both machines is 24.9%

Accept Reject Rule

1. Compare it with a predetermined rate of return or cut-off rate.

If ARR is greater than cut-off, accept the project else reject.

2. Another option is to use a ranking where projects having higher ARR are preferred to projects having lower ARR.

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### Demerits Continued

Lastly, this method does not take into consideration any benefits which can accrue to the firm on account of sale/abandonment of equipment which is replaced by new machine.

###  It does not differentiate between the size of the investment required for the project. In the following example, ARR for all three machines is same but the investment of machine B is lowest.

Machines Average Annual Earnings

Average

Investment ARR (%)

A Rs. 6,000 30,000 20

B 2,000 10,000 20

C 4,000 20,000 20

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## References

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