# Year 1 1 0751 1 1 3 1 33 arr the following data

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year = 1 = 1 = 0.751 (1 + 1) 3 1. 33 ARR The following data relating to two machines x and y Mac x Mar y Original cost Rs.2,00,000 Rs.2,00,000 Estimated life in year 5 5 Expected salvage value Rs. 20,000 Rs. 40,000 Additional working capital Needed on average Rs. 40,000 Rs. 30,000 Income tax rate 40% 40% Estimated incomes before depreciation and tax X y 1 st year 60,000 1,00,000 2 nd year 80,000 80,000 3 rd year 1,00,000 1,60,000 4 th year 1,20,000 40,000 5 th year 1,40,000 1,80,000 Depreciation is to be charges under SLM. you are required to calculate the accounting rate of return on the average investment for both the machines. Solution ARR on average investment = average annual net earnings x 100 Average investment Aug Invest = org. invest scrap values + Add net + scrap value working 2 capital

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248 Mac X = 2,00,000 20,000 + 40,000 + 20,000 2 = Rs.1,50,000 Mac Y = 2,00,000 40,000 + 30,000 + 40,000 2 = Rs.1,50,000 ARR of Mac X = 38,400 x 100 = 25.6% 1,50,000 Working notes Calculation of average annual net earnings Mac X Ave annual earnings before dep and tax 60,000 + 80,000 + 1,00,000 + 1,20,000 + 1,40,000 = 1,00,000 5 (-) Dep. 2,00,000 20,000 = 36,000 5 64,000 (-) Tax at 40% = 64000 x 40% = 25600 Average annual net earnings, after = 38400 Dep. and tax Mac Y Avg annual earnings before depreciation and tax
249 = 1,00,000 + 80,000 + 1,60,000 + 40,000 + 1,80,000 = 1,12,000 5 (-) Dep. 2,00,000 40,000 = 32,000 5 = 80,000 (-) Tax 40% = 80,000 x 40% = 32,000 Ave annual net earnings after dep and tax = 48,000 Profitability Index and NPV method Two projects a and b which mutually exclusive are being under consideration. Both of them require an investment of Rs.1,00,000 each. The net cash inflows are estimated as under. Year A B 1 10,000 30,000 2 40,000 50,000 3 30,000 80,000 4 60,000 40,000 5. 90,000 60,000 The company’s targ eted rate of return on investment is 12% you are required to access the projects on the basis of the present values, using, 1)NPV Method 2) Profitability Index Method. Present values of Re 1 at 12% interest for five years are given below. 1 st year : 0.893 : 2 nd Yr : 0.797 ; 3 rd year 0.712 ; 4 th year 0.636 ; 5 th year 0.567 Statement showing present values of projects Year PV lf Re 1 at 12% pa Project A cash inflows Project B Present value Cash inflow P.V. (1) (2) (3) (4) (5) (6) 1. 0.893 10,000 8930 30,000 26790 2. 0.797 40,000 31880 50,000 39850 3. 0.712 30,000 21360 80,000 56,960 4. 0.636 60,000 38160 40,000 25,440 5. 0.567 90,000 51,030 60,000 34,020 1,51,360 1,83,060

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250 1) NPV Project A B Present value of cash inflow 1,51,360 1,83,060 (-) Initial invest 1,00,000 1,00,000 51,360 83,060 Project B is accepted because higher NPV 2) Profitability Index (PI) PI = PV of cash inflow PV of cash outflow Project A Project B PV of cash inflows 1,51,360 1,83,060 PV of cash outflow 1,00,000 1,00,000 (Initial invest) PI = 1,51,360 1,83,060 1,00,000 1,00,000 = 1.5136 1.8306 Project B is accepted because higher P.I 19.4 REVISION POINTS 1. Pay Back Method It gives the number of years in which the total investment in a particular capital expenditure pays back itself. 2. Accounting Rate of Return method, capital projects are ranked in order of earnings. Projects which yield the highest earnings are selected and others are ruled out. 3. Average Rate of Return method establishes the ratio between the average annual profits and total outlay of the projects. 4. Earnings per unit of money gives us the average rate of return per unit of amount (i.e. per rupee) invested in the project.
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