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Investment appraisal technique Accounting rate of return (ARR)

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ARR measures the impact of an investment on accounting Profit, This method of appraising a project is that the main factor determining the worth of an investment is the level of profitability that may be achieved from such investment.

Prepared by William Armah for warmah.com

ARR uses profit and not cash flow , hence where accounting profit is provided, then all you need to do is to find the average of such profit.

BUT Where the question is given in cash flows, you need to less the depreciation to obtain the accounting profit.

Prepared by William Armah for warmah.com

To obtain profit, given cash flows Profit before depreciation (cash flow) X Less: Depreciation (X) Profit after depreciation (accounting profit) X To obtain cash flow using profit Profit after depreciation (accounting profit) X Add back : Depreciation (X) Profit before depreciation (cash flow) X
Prepared by William Armah for warmah.com

ARR (or ROCE) =

Average Profit after depreciation Original capital Investment

X 100

or

ARR (or ROCE) average method =

Average Profit after depreciation Average of capital Investment*

X 100

* Average of capital investment

original capital + residual value 2

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Initial investment 100,000 Residual value 20,000 Life of investment 4 years Accounting profit: Year 1 15,000 Year 2 20,000 Year 3 25,000 Year 4 30,000 What is the accounting rate of return (ARR)
Prepared by William Armah for warmah.com

Average profit (over 4 years) = (15,000 + 20,000 + 25,000 + 30,000) / 4 = 22,500 Average capital invested = (initial investment + residual value) / 2 = (100,000 + 20,000) / 2 = 60,000

ARR = (22,500 / 60,000) * 100 = 37.5%


Prepared by William Armah for warmah.com

Initial investment 100,000 Residual value 20,000 Life of investment 4 years Profit before depreciation (i.e. Cash flow): Year 1 Net cash flow 35,000 Year 2 Net cash flow 40,000 Year 3 Net cash flow 45,000 Year 4 Net cash flow 50,000 What is the accounting rate of return (ARR)
Prepared by William Armah for warmah.com

Depreciation = (Initial investment Residual value) / useful life

(100,000 - 20,000) / 4 = 20,000


Year Cash flow Depreciation = Accounting profit

1 2 3 4

35,000 40,000 45,000 50,000

20,000 20,000 20,000 20,000

= = = =
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15,000 20,000 25,000 30,000


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Average profit (over 4 years) = (15,000 + 20,000 + 25,000 + 30,000) / 4 = 22,500 Average capital invested = (initial investment + residual value) / 2 = (100,000 + 20,000) / 2 = 60,000

ARR = (22,500 / 60,000) * 100 = 37.5%


Prepared by William Armah for warmah.com

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Total profit before depreciation (cash flow)= (35,000 + 40,000 + 45,000 + 50,000) = 170,000 Total depreciation (cost residual value) = (100,000 20,000) = 80,000 Profit after depreciation = 170,000 80,000 = 90,000 Average profit (over 4 years period) = 90,000 / 4 = 22,500
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Average profit (over 4 years) = 22,500 Average capital invested = (initial investment + residual value) / 2 = (100,000 + 20,000) / 2 = 60,000 ARR = (22,500 / 60,000) * 100 = 37.5%

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Single project Accept investment: if the ARR is more than the cost of capital or the expected return from the investment

Reject investment: if the ARR is less than the cost of capital or the expected return from the investment

Two or more competing projects Accept investment: with the highest ARR and such ARR is more than the expected return from the investment otherwise reject
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It is simple to calculate and easy to understand It is consistent with the short-term profit maximising objective It is consistent with the return-on-investment measure used to compare divisional performance in many companies. It considers the entire of the investment life

Prepared by William Armah for warmah.com

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It is an average and hence takes no account of the timing of the profit Does not consider the time value of money It does not account for differing lives of projects It takes no account of the size of the investment It is a profit measure hence can be easily manipulated. Decision criteria is subjective

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