the 1-11v11 ~- -

Meaning & Concept:

In this method the profits earned on the amount of investment proposal is expressed in
terms of percentage, hence this method is also called Return on investment method. Thus
accounting rate of return divides the average profit by the average investment in order to
get the ratio or return that can be expected. This allows enterprise to easily compare the
profit potential of investment proposals.

Procedure for calculating accounting rate of return:

ARR is calculated with help of following equation:

ARR= Average annual cash flows or Average return x

100
Average Investment
1. The first step is find out the average annual cash flows, average annual cash flows here
indicates cash flows earned from the investment proposal during its economic life divided by
period of cash flow generation. The cash flows are averaged to ensure that balance between

4.31
 variation in cash flows received from the project during its economic life. Ther
. h . 1·~ e,orea
annual cash flow = Sum of cash inflows durmg t e economic ,,e of the investm
.
"eraa
entp,0 ~e
after depreciation and tax + period of cash flow generat,on. 1Josa,
Cash flows means - Cashflow after Depreciation after Tax (CFADAT), one of
. b
for terming this method as Accounting rate of return 1~ ecause this method i
the re
aSon
. . f'ts
conventional accounting concept as 1t takes accounting pro I as cash flows (ds based
. on
eprec,ati
is not added back- (see page No. 4.16) on
2 The second step is to determine average investment, this is calculated by using a
• ny of the
. following equation.
Initial Investment OR
1. Average Investment=-------
2

Initial Investment - Scrap Value

2. Average Investment= - - - - - -- - - - - - OR
2

3. Average Investment
Initial Investment-Scrap Value [S
+ crapva 1ue +
·Add't· w
11ona 1 orkingCapital]
2

Which is the most appropriate equation?

The third equation is more appropriate to calculate because estimated value that an asset
will realize upon its sale at the end of its life is considered further assets require additional
working capital to operate (taken into account at the beginning of the project when calculating
the initial investment). On account of termination of project or end of asset's life, working capita! ,
requirement associated with asset or project also ends resulting in the cash inflow. This means
the working capital utilized during the life of the project or asset will realizable by the firm. In case
working capital is not given it is advisable to use equation 2, in case working capital is given it is
advisable to use equation 3.
Acceptance and rejection criteria:
. I
In case of independent investment proposals we have to compare ARR of the pro~
wi th the expectation of management (also called standard or cut-off rate). If the ARR
15

.
more t han or equal to cut off rate proposal should .
be selected, if not reJected. In caseof
mutually exclusive proposals, we have to compare ARR of all the proposals and wh'chever
1
• - . d if it'S a
proposa I has a higher ARR should be accepted. However if cut off rate is given an
. . ind the
mutually exclusive proposal then all the proposals should be evaluated keeping in rn .
expectation of the management.
 Investment Decisions

I
~ 110N.til4:
j t'i . . tending to
invest in a project costing Rs. 2,00,000. The anticipated cash

ft:
15
i ~abs .in roject before depreciation and tax during the first five years are Rs. 40,000,
thI5
5 from ~,ooo, Rs. 36,000 and Rs. 46,000 respectively. The project has a scrape value
0 53
infl 42 ,ooO, R ·ASsuming a 50% tax rate and depreciation on straight line basis. Calculate the
~5- 0 ooo.
RS· 2 ' te of return.
of nting ra
aceou .
501pt1on: term1·nation of Average Annual cash flows (after depreciation and tax):

1/:- year
A
cash flows
B
Depreciation
C=A-B
CFADBT
D
TAX@50%
E=C-D
CFADAT
40,000 36,000 4,000 2,000 2,000
42,000 36,000 6,000 3,000 3,000
38,000 36,000 2,000 1,000 1,000
--;- 36,000 36,000 0 0 0
46,000 36,000 10,000 5,000 5,000

-
L---"" Total of Cash flows (CFADAT) 11,000
Therefore, Average annual cash flows = Total of Cash flows (CFADAT) + Period of cash flow
generation or life. = 11,000 + 5years = 2,200.
Step 2. Determination of Average investment

Initial lnvestment-ScrapValue + 2,00,000-20,000Rs. ,

Average Investment=------------ 90 000
2 2
Step 3. Calculation of Accounting Rate of Return:
Average annual cash flows
ARR = - - - - - - - - - x 1 0 0
Average Investment

22
ARR= • 00 x100=2.44%
90,000
End Notes:
1 This ·
is an independent project

2. Depreciation= Cost of asset- Scrap value 2 00 000 20 000

Depreciation= ' ' - ' = 36,000 p.a
Life oftheasset 5Years
3. For ARR method w . . .
1n the Quesr . e need cash inflows after deprec1at1on and after tax, (CFADAT or PADAT), however the cash flows give
4. SO% ta . ion is before depreciation and before tax, therefore we must deduct depreciation and tax.
5 s· X IS Calculated on CFADBT
. ince working capital . f . . . .
in ormat1on 1s not given, therefore equation two is used to calculate Average investment
I- - ~ · financial Management

. . . g to invest in a project, the details of which are given b

Wayne Enterprises ,s P1anrnn elow
Project 'P'
Particulars
50,000
Investment
4 years
Estimated life in years
Net Profit (after depreciation and tax)
6,000
1year
4,000 -~
2year 7,500
3year 4,500
5,000
4year 3,000
3,000

-
5year -
2,500
Assuming a desired rate of return of 12% suggest which project should be selected.

Solution:
Step 1. Determination of Average Annual cash flows

Project 'P' Project 'Q'

Year CFADAT Year CFADAT
1 6,000 1 8,000
2 4,000 2 7,500
3 4,500 3 5,000
4 3,000 4 3,000
5
-
2,500
Total of Cash flows= 17,500 Total of Cash flows = 26,~
Average annual cash flows = Total of Cash flows (CFADAT) : Period of cash flow generation°~
17,500
AACFs = = Rs. 4,375 AACFs = 26•OOO = Rs. 5,200
4
5
Step 2. Determination of Average investment

Average Investment= Initial investment - Scrap value

2
Project 'P'
Project 'Q'
A ,
'\Verage nvestment = 50,QQQ
= Rs. 25 ,000 75 000 _ R5 37,sOO
2 Average Investment = ' - ·
2
 ~vestment Decisions

ulation of Accounting Rate of Return

3 ca c
I

-· ARR= Average annual cash flows

Average Investment - x 100
Project 'P'
ProJect 'Q'
4,375
ARR == x 100 = Rs. 17.5% ARR==~
37,500 XlO0 = Rs.13.87
ts· The expected rate of return set by the manag .
men · ement 1s 12% b0th .
cted rate set by the management, however Project P sh Id ' proJects meets the
nthe ARR of Project Q. ou be selected as its ARR is better

1. This is mutually exclusive proposal

2. For ARR method
.
we need cash inflows after depreciation and after tax (CFADAT nA
. . . . . •
. . . .
or ,.. DAT), which 1s given in the Questio
Since working capital information 1s not given, equation two is used to calcul t A
3· - . . n
---,------, a e verage investment
.· ' _-,,
USTRATION 4.16:
• II ·i:l;• -.f' @
mpany is requiring a machine which needs an investment of Rs. 3,20,000. The net income
re tax and depreciation is estimated as follows:

1 2 3 4 5
1,60,000 60,000 1,08,000 1,12,000 96,000

ming a 55% tax rate and depre~iation on straight line basis. Calculate the ARR.

1. Determination of Average Annual cash flows (after depreciation and tax):

C=A-B D E•C-D
A B
CFADBT TAX@55% CFADAT
Cash flows Depreciation
52,800 43,200
1,60,000 64,000 96,000
0 -4,000
60,000 64,000 -4,000
24,200 19,800
1,08,000 64,000 44,000
26,400 21,600
64,000 48,000
1,12,000 14,400
32,000 17,600
96,000 64,000 95,000
Total of Cash flows (CFADAT)
f CFADAT) + Period of cash flow
ore, Average annual cash flows = Total of Cash flows (
ation or life. = 95,000 + 5years = 19,000.
I Anancial Management

Step 2. Determination of Average investment

Initial investment - Scrap Value 3,20,000-NA
Average Investment=
2
=- - - 2 - - == Rs.1,60,00o
. . _ Average annual cash floWs
Step 3. Calculation of Accounting Rate of Return. ARR - Average lnvestme"m><10()

ARR- 19,000
- 1, 60,000 X 100 =: 11.87%

End Notes:
1. This is an independent project
Cost of asset - Scrap value 3, 20,000 - NA
2. Depreciation=--------= Depreciation=----= 64,000p.a
Life of the asset 5 Years

3. For ARR method we need cash inflows after depreciation and after tax, (CFADAT or PADAD. The cash flows given .
question is before depreciation and before tax, therefore we must deduct depreciation and tax. in~
4. 55% tax is calculated on CFADBT, Since working capital information is not given, equation 2 is used to calculate A~
investment. Loss incurred can be setoff against the profit.

Funny Cinemas a multiplex is considering the purchase of a Digital projection system for its new
auditorium, the following are the two alternatives available:

Particulars Projector '2D' Projector '3D'

Original Investment 1,50,000 2,50,000
Additional Working Capital 20,000 20,000
"
Estimated Life 5 years 5 years
Salvage Value Rs.10,000 Rs.15,0~
. . - --- ·-
Income Tax Rate 50% 50%
-
-
-----
Annual cash flows (after depreciation and tax)
1year 20,000 15,00o
2 year 30,000 45,000
3year 50,000
4 year 45,000
5year 65,000
40,000
f Return
The enterprise follows straight line method of depreciation use Accounting Rate O
. '
method, you are required to advice the management on acceptability of the_
se proJ
·ector5·
 steP 1· D
eterrnination of Average Annual cash flows:
•
Projector '2D' Projector '3D'
20,000 15,000
30,000 45,000
,¢- 50,000 60,000
3 year 45,000 80,000
4year 40,000 65,000
.,:...:--
5year 1,85,000 2,65,000
~ f cash flows
---;;rage annual cash flows 1,85,000 2,65,000
AACFs = AACFs =
Total of cash flows (CFADAT) + 5 5
period of cash flow generation
or life.
Rs. 37,000 Rs. 53,000
Average Annual cash flows
step 2. Determination of Average investment

Average Investment = Initial investment

2
- Scrap value
+ [ Scrap value + Working Capital]

Project 'P'
Particulars
Average Investment
Average Investment
= 2, 50, 000-15, 000 + [ 15,000+20,000]
= 1, 50,000 -10, 000 + [ 10,000+20,ooo] 2
2
= 1,17,500+35,000= 1,52,500
=70,000+30,000= 1,00,000

Step 3. Calculation of Accounting Rate of Return

Average annual cash flows
ARR=----------x100
Average Investment
- Projector '3D'
- Projector '2D'
53 000
37,000 ARR= ' x100 = 34.75%
ARR= 1,00,000 x100 = 37% 1,52,500
--
: 0mments: Since the ARR of Projector '2D' is higher than Projector '3D', Projector '2D' should be
e ected.
1

End Notes:
1. This is m ut ua II Y exclusive proposal
. ARR method we need cash inflows after depreciation and after tax, (CFADAT or PADAT), w h.1ch .1s given
2· For . .m th e question
.

3. Since WO rk"mg capital information is given, equation three is used to calculate Average .mvest men t

4.3;