Capital Budgeting Unit 3 Part 2
Financial Management Rashid Usman Ansari Reference
Financial Management Khan & Jain
6th Edition
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Project Evaluation
Techniques
A.
Average Rate of Return
It is also known as accounting rate of return method.
Based on accounting information/profit rather than cash flows.
A number of alternative methods to calculate ARR.
No unanimity in terms of definition of the rate of return.
The most common definition is as follows:
ARR=(Average Annual Profits After Tax/Average Investment over the Life of the Project) x 100
Traditional Techniques
The average profits after taxes are determined by adding up the after-tax profits expected for each year of project’s life and dividing the result by the number of years.
The average investment is determined by dividing the net investment by two. It is assumed that firm is using straight line method of depreciation.
On the basis of the above:
Average Investment=Net Working Capital+ Salvage Value +
½ (Initial Cost of Machine-Salvage Value)
Continued
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
Illustration on Calculating
ARR
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.
Solution
Merits
It is easy to calculate and simple to understand.
Discounted cash flow techniques involve tedious calculations.
Total benefits associated with the project are taken into account while calculating ARR. Some methods ignore total benefits.
Demerits
It uses accounting profit rather than cash flows. As we have discussed earlier, cash flow approach is superior to accounting profit approach.
It does not take into account the time value of money.
Benefits in the earlier years and later years cannot be valued at par but this method does the same.
Evaluation of ARR
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
