Week 9 ACCY 111 RJD Lecture 6

Accounting rate of return arr advantages of arr easy

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Accounting Rate of Return (ARR) Advantages of ARR: Easy to calculate and understand Is a measure of profitability that is consistent with ROA (based on accrual performance) ARR uses familiar concepts such as ‘net profit’ and ‘book value of investment’.
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Accounting Rate of Return (ARR) Problems with ARR: ARR uses accounting profit, however over the life of a project, cash flows matter more than accounting profits. It is cash that is used to acquire resources or make distributions to owners. ARR fails to take into consideration the time value of money – it applies the same weightings to profits in all years. The ARR method presents averaging difficulties when considering competing projects of different size.
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Accounting Rate of Return (ARR) ARR fails to take into consideration the time value of money – it applies the same weightings to profits in all years. Project A Project B Project C Inmmediate cost of machine (160) (160) (160) 1 year's time operating profit after depreciation 20 10 160 2 year's time operating profit after depreciation 40 10 10 3 year's time operating profit after depreciation 60 10 10 4 year's time operating profit after depreciation 60 10 10 5 year's time operating profit after depreciation 20 160 10 40 40 40 $ 0000
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Accounting Rate of Return (ARR) The ARR method presents averaging difficulties when considering competing projects of different size. Project A Project B Project C Inmmediate cost of machine (160) (80) (40) 1 year's time operating profit after depreciation 20 5 3 2 year's time operating profit after depreciation 40 5 3 3 year's time operating profit after depreciation 60 5 40 4 year's time operating profit after depreciation 60 5 2 5 year's time operating profit after depreciation 20 80 2 ARR = 50% 50% 50% $ 0000
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Accounting Rate of Return (ARR) What if a proposal has to meet an organisational hurdle rate of 27%? $ Cost of equipment 200,000 Estimated residual value of equipment 40,000 Average annual operating profit before depreciation 48,000 Estimated life of project 10 years Annual straight line depreciation charge 16,000 ($200,000 - $40,000) / 10 ARR = 48,000 - 16,000 ( 200,000 + 40,000 ) / 2 = 26.7% = FAIL
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Average investment calculation Year Cost RV Periods Deptn 200 40 10 16 1 184 2 168 3 152 4 136 5 120 6 104 7 88 8 72 9 56 10 40 Average 120 = (200+184+168+152+136+120+104+88+72+56+40)/2 Alternate 120 = (200+40)/2
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Accounting Rate of Return (ARR) What if the equipment was written off at the end of the ten years – i.e. no disposal value? $ Cost of equipment 200,000 Estimated residual value of equipment - Average annual operating profit before depreciation 48,000 Estimated life of project 10 years Annual straight line depreciation charge 20,000 ($200,000 - $40,000) / 10 ARR = 48,000 - 20,000 ( 200,000 + - ) / 2 = 28.0% = PASS
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Payback Period (PP) The length of time taken to recover the amount of the investment from the net cash flows of the project Net Cash Flows Cumulative Annual Cash Flows Immediately cost of saw mill (1,000,000) (1,000,000) end of year 1 net profit before depreciation 200,000 (800,000) end of year 2 net profit before depreciation 400,000 (400,000) end of year 3 net profit before depreciation 600,000 200,000 end of year 4 net profit before depreciation 600,000 800,000 end of year 5 net profit before depreciation 200,000 disposal proceeds 200,000 1,200,000 Payback Period = 2.67 years
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