Average Rate of Return (ARR) Homework Help & Tutoring
Average Rate of Return Assignment Help:
According to this method, the capital investment proposals are judged on the basis
of their relative profitability. For this purpose, capital employed and related
incomes are determined according to commonly accepted accounting principles and
practices over the entire economic life of the project and then the average yield
is calculated. Such a rate is termed as Accounting rate of return. It may be calculated
according to the following methods:
ARR = Annual average net earnings after taxes X 100
Average investment over the life of the project
ARR = Annual average net earnings after taxes X 100
Original Investment
ARR = Annual average net earnings after taxes X 100
Average investment over the life of the project
ARR = Annual average net earnings after taxes X 100
Original Investment
The term "average annual net earnings" is the average of the earnings after depreciation
ad taxes over the whole of the economic life of the project. In case of
annuity, the average after tax earnings is equal to any years’ earnings.
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The amount of "average investment" can be calculated according to any of the following methods:
Case 1: If there is no salvage value:
Average Investment = Initial investment/2
Case 2: If there is a salvage value for the asset:
Average investment = (Initial investment-Salvage value)/2
Case 3: If there is a requirement for working capital in the first year:
Average investment = (Initial investment-Salvage Value)/2 + Working capital + Salvage value.
The working capital is generally released at the end of the project's life.
Accept/Reject Criterion: Normally, business enterprises fix a minimum rate of return. Any project expected to give a return below this rate will be straight away rejected. In case of several projects, where a choice has to be made, the different projects may be ranked in the order of their rate of return and the project giving the highest rate of return would be selected.
The amount of "average investment" can be calculated according to any of the following methods:
Case 1: If there is no salvage value:
Average Investment = Initial investment/2
Case 2: If there is a salvage value for the asset:
Average investment = (Initial investment-Salvage value)/2
Case 3: If there is a requirement for working capital in the first year:
Average investment = (Initial investment-Salvage Value)/2 + Working capital + Salvage value.
The working capital is generally released at the end of the project's life.
Accept/Reject Criterion: Normally, business enterprises fix a minimum rate of return. Any project expected to give a return below this rate will be straight away rejected. In case of several projects, where a choice has to be made, the different projects may be ranked in the order of their rate of return and the project giving the highest rate of return would be selected.
Merits of ARR method:
- As against Pay-back method, this method considers the return over the entire economic life of the project.
- The calculation is simple and straight-forward.
De-merits of ARR method:
- Like the pay-back period method, this method ignores the time value of money.
- This method takes into account the accounting profits rather than the cash inflows and hence ignores the fact that the actual cash flows can be re-invested.
- It is the discretion of the management to choose the arbitrary cut-off rate of return in choosing the projects. This may not always ensure the right selection.
- The concept of average investment and average earnings differ widely and hence may produce different results.
Example:- Let us determine the ARR for the following 2 alternative
investments:
ARR = Annual average net earnings after taxes X 100
Average investment over the life of the project
Average earnings = Total earnings / Estimated life in years
For machines A:- $36,875 / 5 = $7,375
For machines B:- $36,875 / 5 = $7,375
Average investment = (Initial investment - Salvage Value) / 2 + Working capital + Salvage value.
For Machine A: ($56,125 - $3000) / 2 + 0 + 3000 = $29,562.50
For Machine B: ($58,125 - $3000) / 2 + 0 + 3000 = $30,562.50
ARR for Machine A : 7375/29562.50 * 100 = 24.95% or 25%
ARR for Machine B : 7375/30,562.50 * 100 = 24.13% or 24%.
Machine A would be preferred as ARR is higher.
| Machine A: | Machine B: | |
| Cost | $56,125 | $58,125 |
| Annual estimated income after depreciation & tax | ||
| Year 1 | $3,375 | $11,375 |
| Year 2 | $5,375 | $9,375 |
| Year 3 | $7,375 | $7,375 |
| Year 4 | $9,375 | $5,375 |
| Year 5 | $11,375 | $3,375 |
| Total earnings | $36,875 | $36,875 |
| Estimated life | 5 years | 5 years |
| Estimated salvage value | $3,000 | $3,000 |
ARR = Annual average net earnings after taxes X 100
Average investment over the life of the project
Average earnings = Total earnings / Estimated life in years
For machines A:- $36,875 / 5 = $7,375
For machines B:- $36,875 / 5 = $7,375
Average investment = (Initial investment - Salvage Value) / 2 + Working capital + Salvage value.
For Machine A: ($56,125 - $3000) / 2 + 0 + 3000 = $29,562.50
For Machine B: ($58,125 - $3000) / 2 + 0 + 3000 = $30,562.50
ARR for Machine A : 7375/29562.50 * 100 = 24.95% or 25%
ARR for Machine B : 7375/30,562.50 * 100 = 24.13% or 24%.
Machine A would be preferred as ARR is higher.
