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Week 9 ACCY 111 RJD Lecture 6

# Accounting rate of return arr the accounting rate of

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Accounting Rate of Return (ARR) The accounting rate of return on the investment in the new saw mill will be : (240,000 / 600,000) * 100% = 40%

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Accounting Rate of Return (ARR) ARR Decision Rules: For any project to be accepted, it must achieve a target ARR as a minimum; If there are competing projects that exceed the minimum rate, the one with the highest ARR would normally be chosen
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.
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
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
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

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Accounting Rate of Return ARR The accounting rate of return...

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