Capital Budgeting Unit 3 Part 2

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Capital Budgeting Unit 3 Part 2

Financial Management Rashid Usman Ansari Reference

Financial Management Khan & Jain

6th Edition


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Project Evaluation




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)



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



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.




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.


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


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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