Accounting

Rate of Return (ARR)

• Also known as Average Rate Of Return Or Return On Capital Employed
• Measures the rate of accounting profit that project will generate on its investment
• Two different formulas are used to calculate ARR;

ARR = Estimated average annual accounting Profit
Initial Investment
or
ARR = Estimated average annual accounting Profit
Average Investment

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Average Investment = initial investment + Scarp value (scrap value)

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2
Year Project A (000) Project A (000)
Investment (90) (20)
1 40 10
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2 30 8
3 20 6
4 20 4
5 20 4
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5 (Residual value) 4 2

Steps to calculate ARR - initial investment & average investment Project A Project B
PA

,000 ,000
Accumulated operating cash flows over the life of project 130 32
Less: accumulated accounting depreciation (initial investment - residual value) (86) (18)
Accumulated Annual accounting Profit 44 14
Divided by: Project Life 5 5
Estimated average annual accounting profit 8.80 2.80
divided by: Initial Investment 90 20
Accounting Rate of Return (ARR) 10% 14%

Estimated average annual accounting profit 8.80 2.80
divided by: average Investment = (initial inv. + residual value) / 2 47 11
Accounting Rate of Return (ARR) 19% 25%
Conclusion: Project with higher ARR is better B is Better

If project ARR is > Standard ARR Accept the project

If project ARR is < Standard ARR

Reject the project

Advantages:
1. Consider whole life of the project
2. Easy and simple to calculate
3. Has some measure of return on investment unlike payback period
4. Can be calculated on available data

Disadvantages:
1. Based on accounting profit
2. Ignore time value of money
3. Not an absolute measure of return.

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Time Value of Money:

• Money losses its value with the passage of time.

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• The money we have today will not have the same value tomorrow.
• This occurs due to three reasons;
1. Opportunity cost of money (potential for earning interest)
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2. Inflation
3. Risk (effect of uncertainty)

In investment appraisal we have to compare Cost with its associated Benefits

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Year Project A (000)
Investment (90)
1 40
PA

2 30
3 20
4 20
5 20
5 (Residual value) 4

Here cost is = Rs,90,000/-
And Benefit = Rs.134,000/-

Question is whether benefit of Rs.134,000/- is more than the Cost Rs.90,000/- . but the time value
of money suggest that these are not comparable due to timing differences, as investment will be
made today and benefits will be received in future 5 years.

In order to understand this we need to learn such technique which shall help us in estimating
“how much a cash to be received in future is worth now”.

Compounding: calculate future value that we will get if we invest some money in present at given
rate, after certain period of time.

Basic formula for compounding is

FV = PV (1 + r)^n

Example # 1 :
How much money we receive in 5 year’s time if we invest Rs.10,000 today in a bank at 10% p.a.

Example # 2 :
Calculate the value of Rs.38,000/- invested for 7 years at 5% p.a.

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Discounting: is just opposite to compounding. It enable us to calculate value of future flows
today.

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Year 0 1 2 3 4 5

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PV

Discounting FV


PV = FV x 1 ,
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(1+r)^n
Example # 1 :
What should be invested Now to receive Rs.10,000 in 4 year’s time if rate of interest is 10% p.a.
PA

Example # 2 :
What is the Present Value of Rs.115,000/- receivable in 9 years at 6% p.a.

NET PRESENT VALUE
This technique eliminates the timing difference of cash flows and makes comparison of
investment with the associated benefits. It is calculated as under;
NPV = Present Value of future benefits – Present value of Investment
Project A Project B Discounting PV of Project PV of Project
Year ,000 ,000 @ 10% A B
Investment (90) (20) 1.0000 (90) (20)
1 40 10 0.9091 36 9
2 30 8 0.8264 25 7
3 20 6 0.7513 15 5
4 20 4 0.6830 14 3
5 20 4 0.6209 12 2
Net Present Value 12 5
Conclusion: Project with more +NPV is better A is better

If NPV is positive

Accept the project
If NPV is negative Reject the project


Types of Discounting:

There are different types of discounting with reference to cash flows;

1. Discounting a single sum.
2. Discounting annuity (for constant annual cash flows for a number of years)

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• Normal
• Advanced
• Delayed

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3. Discounting Perpetuity
• Normal
• Advanced
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• Delayed

Annuity Discounting – Normal

PV = Annual Cash flow x 1 – (1+r)^-n
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r
Project A Project B Discounting PV of PV of Project
Year ,000 ,000 @ 10% Project A B
PA

1 25 7 0.909 23 6
2 25 7 0.826 21 6
3 25 7 0.751 19 5
4 25 7 0.683 17 5
5 25 7 0.621 16 4
3.791 95 27
PV of Project A 25 x 3.791 95
PV of Project B 7 x 3.791 27