Computation The average rate of return (AM) method of evaluating proposed capital expenditure is also known as the accounting rate of return method. It·is based upon accounting information rather than cash flows. There is no unanimity regarding the definition of the rate of return There are a number of alternative methods for calculating the ARR.The most common usage of the
average Tate of return (ARR) expresses it as follows:
The average profits after taxes are determined by adding up the after-tax profits expected for , each year of the project’s life and dividing the result by the number of years. In the case of annuity, the average after-tax profits arc equal to’ any year’s profits, The average investment is determined by dividing the net investment by two. This averaging process assumes tout the firm is using straight line depreciation, in which case the book value of the asset declines at a constant rate from its purchase price to zero at the end of its appreciable life. This means that, on the average, firms will have one-half of their initial purchase price in the ‘books,” Consequently, if the machine has salvage value, then only the decipherable cost (costs salvage value) of the machine should be divided by two in .order to ascertain the average net investment. a:~the salvage money will be recovered only at the end of the life of the project. Therefore, an amount equivalent to the salvage value remains tied up in the project throughout its life time. Hence. no adjustment is required to the sum of salvage value to determine the average investment.? Likewise, if any additional net working capital is required in the initial year which is likely to be released only at the end of the project’s life, the full amount of working capital should be taken in determining relevant investment for the purpose of calculating ARR. Thus.
Average investment = Net working capital + Salvage value + III (initial cost of machine Salvage value)
for instance, given the information: initial investment (purchase of machine), Rs 11.000, salvage value, Rs 1,000, working capital, Rs 2,000. service life (years) 5 and that the straight line method of depreciation is adopted. the average investment is: Rs 1,000 + Rs 2,000 + 112 (Rs 11,000 – Rs.l,000) = Rs 8,000.
Determine the average rate pf return from the following data if two machines, A and B.
Depreciation has been charged on straight line basis.
In addition to the above, there are other approaches to calculate the average rate of rerun CARR). One approach. which is a variation of the above. involves using original rather that tile average CO$ to the project. In the case. of this alternative ‘approach, the Are for both the machines would be 13.1 per cent (Rs 7,375 + Rs 56.125).