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What is Accounting Rate of Return in discounted cash flow technique in capital budgeting?
ARR stands for Accounting Rate of Return. It is one of the Non- Discounted cash flow techniques used for calculating capital budgeting.
ARR is the average net income of an asset (anticipated) divided by its average capital cost. It is generally expressed as an annual percentage. ARR does not take in account the time value of money or cash flows, which are integral part of maintaining a business.
ARR is useful for a quick calculation of an investments probability.
ARR is mainly used for comparison between multiple projects to determine the ARR for each.
ARR is mainly used for comparison between multiple projects to determine the ARR for each.
$$ARR=\frac{Average\:net\:profit}{average\:investment}$$
Average profit = total profit over investment period/ number of years.
Average investment = (book value at first year + book value at end of useful life)/2.
Examples
Company X is looking to invest in some new machinery to replace its current one.
New machinery details −
Cost : Rs.4, 20,000/- would increase annual revenue by Rs.2, 00,000/- Annual expenses : Rs.50, 000/- Life of new machinery : 12 years Salvage value : 0
Solution
Step 1 − Calculate depreciation expenses per year.
Depreciation expense per year =$\frac{cost\:of\:machinery}{life\:of\:machinery} \Rightarrow\frac{420000}{12}\Rightarrow$Rs. 35000/-
Step 2 − Calculate average annual profit.
Average annual profit = annual revenue of new machinery – (annual expenses + step 1)
= 200000 – (50000+35000) => Rs. 1,15,000/-
Step 3 Calculate ARR by using above formula.
$$ARR=\frac{step 2}{total\:cost} \Rightarrow\frac{115000}{420000}\Rightarrow27.4\%$$
That means for every Rs.100/- invested, investment will return a profit of about Rs.27/-
Company Y is considering investing in a project that requires an initial investment of Rs. 1, 00,000/- for some machinery. There will be net flows of Rs. 20,000/- for first two years and Rs. 10,000/- for year 3 & 4, and Rs. 30,000/- for year 5. Machine has a salvage value of Rs. 25,000
Solution
Step 1 − Calculate average annual profit.
| Inflow | Rs. | |
|---|---|---|
| YEAR 1 & 2 | 20000*2 | 40000 |
| YEAR 3 &4 | 10000*2 | 20000 |
| YEAR 5 | 15000 | 30000 |
| (-) Deprecation | 100000-25000 (salvage value) | (75000) |
| Total profit of project | 15000 |
$$ARR=\frac{total\:profit\:of\:project}{life\:of\:project} \Rightarrow\frac{15000}{5}\Rightarrow3000/-$$
Step 2 − Calculate average investment.
$$Average investment =\frac{100000+25000}{2} \Rightarrow Rs.62500/-$$
Step 3 − Calculate ARR.
$$ARR=\frac{step 1}{step 2} \Rightarrow\frac{3000}{62500}=4.8\%$$
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