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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
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Having calculated the return,we still do not know whether the return is acceptable or not?
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- Investment Appraisal Methods:Internal Rate of Return (IRR)
- Investment Appraisal Methods:Pros And Cons of Internal Rate of Return.
- Main Content Page For Articles On Investment Appraisal Methods/Techniques/Management
- Rate Of Return Or Rate Of Investment Pricing Methodology(Part4)
- Investment Appraisal Methods:Net Present Value ( NPV)
- Investment Appraisal Methods orTechniques:Payback Period
- Investment Appraisal Methods:Using The Profitability Index,Its Usefulness And Critique
FCCA,CA(MIA)with more than 26 years of post-qualifying working experiences. Previous working stints with one of the big accounting four,Regional GFC & Group Treasurer in a group of Malaysian and Group CFO in Singapore public listed concern.Also author to another very popular free educational accounting cum finance blog:http://basiccollegeaccounting.com under the branding of College Accounting Coach.
examples for application of ARR method