1. 16BA624/FINANCIAL MANAGEMENT
ARR
P.Krishnaveni/
16BA624/FINANCIAL MANAGEMENT

2. Accounting or Average rate of return method
It is known as accounting Rate of return because it takes into account , the accounting concept of profit (i.e profit after depreciation and tax) and not the cash inflows. The project which yields the highest rate of return is selected. Formula : 1.Accounting rate of return on = Average annualprofit x100 original Investment original Investment 2.Accounting rate of return on =Average annualprofit x100 Average Investment Average Investment

3. Average profit = Total profit Number of years Average Investment = Original Investment / 2 (or) = original investment – scrap value /2 (or) = Investment at the beginning+ Investment at the end/ 2 Depreciation =Original value of the asset (or) Estimated life of the asset = Original value of the asset – scrap value

4. 1.Calculate the average rate of return for project A and B from the following: Project A Project B Investment (Rs) Rs.25,000 Rs.37,000 Expected life(years) 4 5 Profit after depreciation and taxes: I year Rs.2500 Rs.3750 II year Rs.1875 Rs.3750 III year Rs.1875 Rs.2500 IV year Rs.1250 Rs.1250 V Year - Rs Total profit Rs.7500 Rs.13,500 which project should be selected?

5. Solution: Project A : 1.Accounting rate of return on original Investment = Annual average profit x Original Investment average annual profit -= Total annual profit No.of years - Rs Average annual profit –=Rs.1875

6. Cont…. Accounting rate of return – Rs. 1875 x 100 ----------- Rs
Cont…. Accounting rate of return – Rs.1875 x Rs Accounting rate of return on original investment - 7.5%

7. Project B : 1.Average rate of return on original Investment : = Average annual profit x Original Investment Average annual profit = Rs = Rs.2700

8. Average rate of return = Rs. 2700 x 100 ----------- Rs
Average rate of return = Rs.2700 x Rs Accounting rate of return on average investment =7.2%

9. 2.Average rate of return on average Investment : Project B
= Average annual profit x 100
Average Investment
Average Investment = Original investment / 2
average annual profit -= Total annual profit
No.of years

10. 3.Rate of return on Investment : Project A
= Total profit x 100
Investment

11. 2. A project cost is Rs. 5,00,000 and has a scrap value of Rs
2.A project cost is Rs.5,00,000 and has a scrap value of Rs.1,00,000 after 5 years. The net profit before tax and depreciation are expected to be Rs.1,00,000 , Rs.1,20,000,Rs.1,40,000,Rs.1,60,000 and Rs.2,00,000.You are required to calculate accounting rate of return, NPV, PBP, PI, Discounted 10% and assuming 50% of taxes and depreciation on straight line.

12. Solution:Working notes: 1
Solution:Working notes: 1.Calculation of depreciation: Depreciation = Original value – scrap value Life of the asset = Rs.5,00,000 – Rs.1,00, = Rs.80,000 5 Profit (1,00,000) -Dep(10,000) Profit after dep before tax (90,000) Tax on 90,000 = 45,000) __________ (ARR)Profit after tax & Dep (45,000) dep (10,000) (PBP, NPV, IRR, PI) Profit before dep after tax (55,000) ====

13. Profit after tax before dep
YEAR
Profit before dep &Tax
Depreciation
After Dep
Tax
Profit after tax & Dep
Profit after tax before dep 1
1,00,000
80,000
20,000
10,000
90,000 2
1,20,000
40,000 3
1,40,000
60,000
30,000
1,10,000 4
1,60,000 5
2,00,000

14. Cont….. 1.Accounting rate of return on original Investment : = Average annual profit x Original Investment Average annual profit = Total profit / No.of years = Rs.1,60, = Rs.32,000 Average rate of return = Rs.32,000 x 100 Rs.4,00,000 Accounting rate of return on average investment =8% 2.Accounting rate of return on average Investment : = Average annual profit x Average Investment

15. Average Investment = Original investment – Scrap value = Rs.5,00,000 – 1,00, = Rs.2,00,000 Accounting rate of return on average investment : = Rs.32,000 x Rs.2,00,000 Accounting rate of return on average investment = 16%