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m NATURE
m NEED
m KINDS OF DECISIONS
m TRADITIONAL METHOD: ARR
p
Analysis of potential additions to fixed assets.
Projects are: mutually exclusive, if the cash flows of one can be adversely impacted by
the acceptance of the other.
Projects are: independent, if the cash flows of one are unaffected by the acceptance of
the other.
m It should maximise the shareholders¶ wealth.
m It should consider all cash flows to determine the true profitability of
the project.
m It should provide for an objective and unambiguous way of
separating good projects from bad projects.
m It should help ranking of projects according to their true profitability.
m It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
m It should help to choose among mutually exclusive projects that
project which maximises the shareholders¶ wealth.
m It should be a criterion which is applicable to any conceivable
investment project independent of others.
m Three steps are involved in the evaluation of an
investment:
- Estimation of cash flows
- Estimation of the required rate of return (the
opportunity cost of capital)
- Application of a decision rule for making the choice
Idea Review of the
generation Project
Evaluation or Execution or
analysis Implementation
Financing the
Selection selected
project
Traditional or Modern or
Non-discounted Discounted
cash flow Cash Flow
Net
Pay !ack
Present
Period
Value
Accounting Internal
Rate of Rate Of
Return Return
Profitability
Index
m ARR method uses accounting information as
revealed by financial statements, to measure the
profitability of the investment proposals. It is also
known as the return on investment (ROI).
Sometimes it is called as average rate of
return(ARR). Average annual earnings after
depreciation and taxes are used to calculate ARR.
It is measured in terms of percentage. ARR may
be calculated in two ways.
m henever it is clearly mentioned as Accounting Rate of
Return
if accounting rate of return is given in the problem,
return on original investment method should be used to
calculate accounting rate of return.
ARR= Average Annual EAT or PAT ×100
Original Investment (OI)*
* OI = Original Investment+ Additional NC+ Installation
charges+ Transportation charge
m (ii) whenever it is clearly mentioned as Average Rate Of
Return
if the average rate of return is given in the problem,
return on average investment method should be used to
calculate average rate of return.
ARR= Average Annual EAT ×100
Average Investment(AI)*
*AI=(Original investment-Scrap Value)1/2+ Additional
NC + Scrap Value
m (iii) if ARR is given in the problem, any of the method
can be used to calculate ARR
(preferably return on average investment method).
DECISION RULE
Acceptance or Rejection of the project decided on the
based comparison of calculated ARR with the
predetermined rate or cut off rate.
Accept: Cal ARR> Predetermined ARR or Cut-off rate
Reject: Cal ARR< Predetermined ARR or Cut-off rate
The ARR method has some merits:
- It is very simple to understand and easy to
calculate.
- Information can esily be from accounting records.
- It takes into account all profits of the projects life
period.
- Cost involvement in calculating ARR is very less
with the comparison of modern methods, since it
saves analyst¶s time.
m It uses accounting profits instead of actual cash flows
after taxes in evaluating the projects.
m It ignores the concept of time value of money.
m It does not allow the fact that profit can be reinvested.
m It does not differentiate between the size of the
investment required for each project.
m It does not take into consideration any benefits, which
can accrue to the firm from the sale of the abundant of
equipment, which is replaced by the new investment.
m It feels that 10 percent rate of return for 10 years
is more beneficial tan 8 percent rate of return for
25 years.
m It is incompatible with the objective of wealth
maximization to the equity shareholders.
m It uses arbitrary cut-off as yardstick or standard for
acceptance or reject rule.