#3 Average Rate of Return (ARR) – Investment Decision – Financial Management ~ B.COM / BBA / CMA #Finance

hi everyone this is the third CashNews.co of investment decision chapter and in the previous CashNews.co we have seen the payback period technique of Capital Budgeting right we have seen this payback period now in this CashNews.co what are we going to do is

in this CashNews.co we are going to see another technique of Capital Budgeting that is Accounting rate of return or you can also call it as average rate of return okay it has two names fine an average rate of return or Accounting

rate of return fine let’s get into it now let’s try to understand this average rate of return technique of Capital Budgeting see here I have written the meaning over here this method takes into account the earnings from the investment over its whole

life see this is very important earnings from the investment whatever earnings the investment that investment will fetch us right those earnings those Accounting Profits are taken into account in this average rate of return technique what here in this technique of

a are our average rate of return Profits Accounting Profits are taken into account earning from the investment suppose if company is considering right these three Investments and they’re evaluating these investment right then

the initial investment of this project a would be 50 lakh right it is 50 lakh so if company invest 50 lakh in this then what all cash inflows it will have in the future right those cash inflows are not Profits are those Profits no they are not they are not

Profits Profits are something that after deducting the tax and the depreciation right depreciation and tax after deducting depreciation and tax that would be Profits so those Accounting Profits are taken into

account here in average rate of return okay so the formula of this technique is a RR see here this is the average rate of return a RR is equal to average Profit divided by average investment okay this is the formula of this technique a RR is equal to average Profit

divided by average investment so now the main thing is how do we calculate average Profit and how do we calculate average investment because obviously it will not be given into the question right if it is given in the question then there is nothing to do just divide right so

that’s not the focus here here you have to calculate the average Profit and averaging less than so how do you go about that see you to calculate Profit as I said simple in the cushion cash inflows will be given cash inflows will be given if invest in any

project right the estimate will be there that this project will fetch us this much Cash Flows cash inflows in the year one it would be ten lag in the year it would be fifteen lag in the year three it would be twenty like like that estimates will be there so on the basis of those

estimates only we evaluate the project right because this is something that will happen in the future it’s uncertain right so yeah so those cash inflows are added up okay all the cash inflows of the whole life okay whatever life is there of that project all the cash inflows will be added and

then depreciation the whole depreciation of that project will be subtracted right for example if this is ten lakh depreciation is two lakh then what is the residual value eight like then tax percentage would be given in the question you have to calculate tax on not on the cash inflow not on the ten

lakh you have to calculate tax on the a eight lag that residual value the value after deducting the depreciation fine okay so that is how you will get the Profit the total cash inflows add them up altogether minus depreciation and then minus PACs and calculate tax after deducting

the depreciation okay don’t calculate tax directly on the cash inflows no okay all right then once you get the Profit then easily you can calculate the average Profit that is Profit whatever Profit you got here

Profit divided by number of years that would fetch you the average Profit now what is this number of years the years that is estimated that project will continue okay that is the number of years the life of the project fine yeah then your first thing is done the

average Profit is done right first work is done the second average investment how do you calculate a investment see to calculate average investment there is a simple formula see here average investment is equal to initial investment initial investment means the outflow the first

outflow whatever money we invest right whatever money the company invests that is the initial investment right initial investment plus scrap value the scrap value means the value which you would fetch at the last the termination value of the project that is the scrap value so you will add those two

together and then divided by 2 okay you are calculating average investment so you are dividing it by 2 and then at last if there is any additional working Capital given in the question at last add it up ok at last add this additional working Capital what is

additional working Capital sometime what will happen sometime in the project they would need some funds in between in between of the project right so if they estimate that some working Capital would be required then the working Capital will be

given to reading the question and you have to add it to this at last then you will get average investment this simple technique is first do this ok initial investment plus craft value divided by 2 and then whatever answer you get added with the additional working Capital okay

don’t add this first add this at last okay add the additional working Capital at last fine so this is how you will you calculate the average Profit and then average investment and once you divide that you will get average rate of return it will be in form of

of course percentage write rate it is rate so it will be in form of percentage and then you will compare the compare the percentages the AR are of different different projects and you will select the project which has the highest AR are the highest average rate of return fine so that is what is

there in average rate of return here you focus on the Accounting Profits so that is why this method is also known as Accounting rate of return okay this method is also known as this technique is also known as Accounting rate of

return fine so this is it now let’s see the problem let’s solve the problem of this AR AR and you will get more okay you will understand more fine okay then let’s go to the now let’s solve this problem see here here’s the question initial investment 1 lakh sixty

thousand right initially in this project we are going to invest how much 1 lakh sixty thousand fine and then they have said no scrap value right so we have to ignore the scrap value if you have to consider there is no scrap value and we have to take scrap value s nil fine and then they have given

us the cash inflows see here cash inflows here and here the amount here 156 thousand year to 48 thousand year three thirty thousand a year for sixty four thousand and year five eighty thousand right and then they have said depreciation is on straight-line basis tax rate forty percent right now we

have all we need now let’s start and solve this problem see here first what are we going to do first we are going to write the formula because we need to know what we need to find right so average rate of return is equal to average Profit divided by average investment that is

the formula we need average Profit and we need average investment now we have the formulas over here right how do we calculate Profit to calculate average Profit first we need Profit cash inflows minus depreciation and then minus

tax right that is what we do so let’s do that first see here to calculate that first let’s add up all the cash inflows because here we are considering the whole life of the project right whole life of the project so we have to add up all the cash inflows so cash inflows fifty six

thousand forty eight thousand thirty thousand sixty four thousand eighty thousand we have to add them up okay we have to add all of them right so ignoring the zeros let’s add them up 56 plus ya 56 plus then 48 plus 30 plus and what is the 64 plus 80 that is equal to 278 isn’t it it is

equal to 278 so it is 2 lakh 78,000 that is the total cash inflows right total cash inflow right so we have got total cash inflow now now use that Profit formula right cash inflows minus depreciation minus tax use that Profit is equal to cash inflows the total cash

inflows – the whole depreciation – right now we have the total cash inflow that is 278 we just added that up right so 278 to like 78,000 and then depreciation now how do we calculate depreciation now I have said that here we are considering the whole depreciation how much whole

depreciation whole depreciation so that is why that is why here here how many years are there of this project five years are they right how many years five years and the cost of the investment the initial investment is one like fifty thousand so now you will have to depreciate this right right so

what would be the depreciation of one year the one year depreciation is one like sixty thousand right cost what is the formula of depreciation cost minus scrap value divided by the number of years that is the that is a formula right but we don’t have any scrap value so minus zero that is one

last 80,000 only and then divided by the number of years that is five right so that is 32,000 the depreciation of one year is 32,000 but here we are considering the whole life of the project so we have to take the whole depreciation that is into five that is one last 50,000 but you don’t have

to do all this you don’t have to do that you just have to directly take the initial investment as the depreciation because this whole amount will be depreciated in the five years whole amount because there is no scrap value if there had been scrap value then what would be the depreciation

let’s say scrap value was twenty thousand this for an example scrap value was twenty thousand then that whole depreciation would be 160 minus twenty thousand this was the hold appreciable amount the whole depreciation would be 140 right so that is what you have to take whole here because

entire thing will be depreciated in the period of five years okay that is what so you have to take the whole deposition that is one like thirty thousand the entire initial investment the entire cost would be depreciated in the five years so you have to take the entire depreciation we are

considering the whole life of the project in this average rate of return so whole depreciation you have to take okay okay so don’t get confused in that okay how do you calculate that symbol if there is scrap value just subtract the scrap value from the initial investment okay 160 if there is

scrap value let’s say 10 so minus 10 right 150 would be the depreciation if the scrap value would have been 50 50 thousand then the depreciation would have been 1 lakh 60 minus 50 thousand right so one lakh 10 would be the depreciation this is how you have to do it okay don’t worry so

cash inflows minus depreciation 1 lakh 60,000 in the higher thing would be depreciated okay entire thing would be depreciated because there is no scrap value so entire thing would be depreciated so you have to take that whole thing and then you have to calculate tax okay so 278 yeah – like 78

thousand – 160 thousand that is a depreciation when the residual value get us one lakh 18000 now on this one like eighteen thousand you have to calculate the tax and the tax percentage is given in the question as forty percent isn’t it it is given as 40 percent so on this you have to

calculate 40 percent in to 40 percent that is equal to 40 7200 so the tax is 40 7200 right you have to calculate the tax on the residual value not on the cash inflow fine you saw right how we did that yes and then this is a tax 40 7200 write that down and then do it again – 78 yeah –

160 minus 40 7200 the tax you will find 70 thousand 800 as the Profit now this is the total Profit this is the total Profit okay after considering the depreciation and after considering the tax after deducting them up this is the total

Profit of the five years now you have to find annual average Profit you have to find average Profit so to find out average annual Profit what do you do you just divided by the life of the project the number of years to calculate

average Profit divided by number of years just do that number of years so if you do that you would get fourteen thousand one hundred and sixty right let’s try that 70 thousand eight hundred divided by five would fetch us 14,000 160 this is the average Profit

so one thing is done right we have calculated the average Profit now we have to calculate the average investment isn’t it now how do we go about that how do we calculate average investment the formula is initial investment plus scrap value divided by 2 plus additional working

Capital but here in this question do we have scrap value no no scrap value no additional working Capital nothing so what are they going to do be able to ignore this completely ignore this right because there is no scrap value with no working

Capital given no additional working Capital given only initial investment we have so that is all we are going to take initial investment yeah one lakh 60,000 divided by two that would fetch us 80,000 80,000 is the average investment if there would have been scrap

value an additional working Capital then we would have taken them here but now there is nothing so we have to only take initial investment okay so one lakh 60,000 divided by 2 that is 80,000 fine so we have got we have got the average Investments so once we get

average Profit and average investment then it’s very simple right just divide it up right just divide them up and find out the average rate of return right so that is what we are going to do 14,000 160 divided by 80,000 yeah so and then you have to multiply it by 100 because

here we are finding out in terms of percentages so in 200 that gives you 17.7 percentage right 17.7 percentage that is how you do it it’s very simple right what do you do first first you have to add up all the cash inflows right you can also do it in the table form also k1 by 1 you can take

the cash inflows and then calculate the depreciation first and to calculate depreciation it’s very simple okay if there is no scrap value whatever cost is there the entire thing would be the depreciation keep that in mind and then the tax right and if there is scrap value here then just

subtract the scrap value that whole thing would be the depreciation the entire depreciable amount whatever that would get depreciated right that is what you have to take over here and then tax tax calculate it on the residual value so that is how you do it and then average investment is initial

investment plus scrap value divided by two and if there is any additional working Capital then after calculating this then add it with the additional working Capital okay so that is how you go about it it’s very very simple okay all right then in the next

CashNews.co we are going to see net present value and if you want we can also do a combined problem okay