78106_10_Web_Ch10A_p01-02

78106_10_Web_Ch10A_p01-02 - WEB EXTENSION The Accounting...

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Unformatted text preview: WEB EXTENSION The Accounting Rate of Return (ARR) 10A T his Web extension describes the accounting rate of return (ARR), which focuses on a project's net income rather than its cash flow. The ARR calculation is illustrated in Figure 10A-1. In its most commonly used form, the ARR is measured as the ratio of the project's average annual expected net income to its average investment. If we assume that Projects S and L, as described in Chapter 10, will both be depreciated by the straight-line method to a book value of zero, then each will have a depreciation expense of $10,000/4 = $2,500 per year. The average cash flow minus the average depreciation charge is the average annual income. For Project S, average annual income is $750: Average annual income Average cash flow - Average annual depreciation $5;000 $4;000 $3;000 $1;000=4 $2;500 $750 The average investment is the beginning investment plus the ending investment (the salvage value), divided by 2, or $5,000: Average investment Cost Salvage value=2 $10;000 $0=2 $5;000 This $5,000 is the book value of the asset halfway through its life. Dividing the average annual income by the average investment, we obtain an ARR for Project S of 15%: Average annual income $750 15% ARRS Average investment $5;000 By a similar calculation, we determine ARRL to be 23.75%. Thus, the ARR method ranks Project L over Project S. If the firm accepts projects with an ARR of 16% or more, then Project L will be accepted but Project S will be rejected. Note also that, for these two projects, the rankings under the ARR method are the opposite of those based on either payback method. We could argue about which method is better and hence which set of rankings should be used. However, this would be a fruitless argument, because ARR is badly flawed in the same way that payback is flawed; both the regular payback and the ARR ignore the time value of money. Because this procedure does not provide complete information on the project's contribution to the firm's value, it could lead to incorrect capital budgeting decisions.1 1 Actually, there are many ways to calculate the ARR. Because all of them have major deficiencies, we see no point in extending the discussion. 1 2 Web Extension 10A: The Accounting Rate of Return (ARR) FIGURE 10A-1 Accounting Rate of Return ARR = Average annual cash inflows Average annual depreciation Average Investment Project S $3,250 $2,500 4 $10,000 $5,000 $750 $5,000 $1,187.50 $5,000 = 15.00% Project L $3,687.50 $2,500 4 $10,000 $5,000 Average CF Average Depreciation Years Investment Avg. Investment ARRS = ARRL = = 23.75% ...
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This note was uploaded on 05/03/2010 for the course FRR 3032 taught by Professor Mr.wroshr during the Spring '10 term at Crafton Hills College.

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