There are many investment appraisal techniques.
Today’s article is confined to the discussion of the Accounting Rate of Return Method or Accounting Return on Book Value. First, we shall go thro’ an illustration to demonstrate how it’s being calculated and then go on with the discussion on its advantages and disadvantages.
Incidentally, the Accounting rate of return is very commonly used as this concept is a very familiar concept to return on investment (ROI), return on capital employed(ROCE) or accounting rate of return(ARR).
The formula for this method is Average Annual Income/Average Annual Investment
Illustration:
Let’s say we are evaluating the below said project with the following Initial Outlay/Investment and Net Cash flow ( Revenue minus Costs)
Investment:
|
|
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Average |
|
Gross Book Value of Investment |
100,000 |
100,000 |
100,000 |
100,000 |
|
|
Depreciation |
|
20,000 |
20,000 |
20,000 |
|
|
Accumulated Depreciation |
|
20,000 |
40,000 |
60,000 |
|
|
Net Book Value |
100,000 |
80,000 |
60,000 |
40,000 |
70,000 |
Returns/Net “Cash flow (Revenue-Costs)
|
|
Year 1 |
Year 2 |
Year 3 |
Average |
|
Revenue(a) |
50,000 |
70,000 |
100,000 |
|
|
Costs (b) |
20,000 |
30,000 |
40,000 |
|
|
Cashflow (a-b) |
30,000 |
40,000 |
60,000 |
|
|
Depreciation |
20,000 |
20,000 |
20,000 |
|
|
Net profit |
10,000 |
20,000 |
40,000 |
23,300 |
Accounting Rate of Return = Average annual returns
Average annual investments
= $23,300
$70,000
= 33.3%
What are then the Pro’s and Con’s of ARR:
|
Pro’s |
Con’s |
|
It takes all the years into account when making an investment decision, |
There is no account of time value of money. It does not take into account the fact that dollars to be received in the future is not worth as much as money in the hand today. |
|
It’s is easy to use and is familiar concept to managers which they refer to as “ return on investment” or “ return on Capital employed. |
It is purely based on accounting figures and not on cash flow. Thus it
|
|
|
Having calculated the return, we still do not know whether the return is acceptable or not?
|
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