#3 Average Rate of Return (ARR) - Investment Decision - Financial Management ~ B.COM / BBA / CMA
Summary
TLDRThis video tutorial introduces the Accounting Rate of Return (ARR) technique for capital budgeting. It explains how to calculate the average profit and investment by considering the project's total cash inflows, depreciation, and taxes. The ARR formula is presented, and viewers are guided through a step-by-step example, emphasizing the importance of understanding accounting profits and comparing the ARR percentages of different projects to select the most profitable one.
Takeaways
- 📈 The video discusses the Average Rate of Return (ARR) technique, an important method in capital budgeting for evaluating investments.
- 💡 ARR focuses on the accounting profits earned from an investment over its entire life, which includes profits after tax and depreciation.
- 🔢 The formula for ARR is Average Profit divided by Average Investment, where Average Profit is calculated by dividing the total profit by the project's life span.
- 💼 The script explains that cash inflows are not the same as profits; profits are derived after accounting for depreciation and taxes.
- 📊 To calculate total profit, the script details a step-by-step process: sum all cash inflows, subtract total depreciation, and then subtract taxes based on the residual value after depreciation.
- ⏱ The script provides a clear example of how to calculate ARR, including the addition of all cash inflows over a project's life, the calculation of annual depreciation, and the application of a tax rate to the residual value.
- 💹 The ARR is expressed as a percentage, which is used to compare different investment projects, with the project having the highest ARR being potentially the most profitable.
- 💡 The script emphasizes that the ARR method is also known as the Accounting Rate of Return, highlighting its focus on accounting profits.
- 📝 The video script also mentions that the ARR method is simple to calculate and understand, making it a useful tool for comparing the profitability of various investment projects.
- 🔍 The video concludes with a problem-solving example, demonstrating the practical application of the ARR technique in evaluating an investment project with given cash inflows, depreciation, and tax rate.
Q & A
What is the main focus of the third video in the investment decision chapter?
-The third video focuses on explaining the Accounting Rate of Return (ARR) technique of capital budgeting, which takes into account the earnings from the investment over its whole life.
What are the two names for the technique discussed in the video?
-The technique discussed in the video is known as both the Accounting Rate of Return (ARR) and the Average Rate of Return.
How is the Average Rate of Return (ARR) calculated?
-The Average Rate of Return (ARR) is calculated by dividing the average profit by the average investment.
What is considered when calculating the average profit in the ARR technique?
-The average profit in the ARR technique is calculated by considering the total cash inflows, subtracting the total depreciation, and then the tax on the residual value after depreciation.
How is the average investment calculated in the ARR technique?
-The average investment is calculated by adding the initial investment and the scrap value, dividing by 2, and then adding any additional working capital if given.
What is the formula for calculating the depreciation of an asset in the ARR technique?
-The formula for calculating the depreciation is the initial investment minus the scrap value, divided by the number of years of the project's life. If there is no scrap value, the initial investment is considered the total depreciation.
What is the significance of considering the whole life of the project when calculating ARR?
-Considering the whole life of the project allows for a comprehensive evaluation of the investment's profitability over its entire duration, taking into account all cash inflows and the full depreciation of the asset.
Why is it incorrect to calculate tax directly on the cash inflows in the ARR technique?
-Calculating tax directly on the cash inflows would not account for the impact of depreciation on the project's profitability. Instead, tax should be calculated on the residual value after deducting depreciation.
What is the purpose of comparing the ARR percentages of different projects?
-Comparing the ARR percentages of different projects helps in selecting the project with the highest average rate of return, which indicates the most profitable investment option.
How does the script illustrate the calculation of ARR with an example?
-The script provides a step-by-step example, starting with the initial investment, calculating cash inflows, depreciation, tax, and then using these figures to find the average profit, average investment, and finally the ARR percentage.
What is the next topic the video series will cover after the ARR technique?
-The next topic the video series will cover is the Net Present Value (NPV) technique of capital budgeting.
Outlines
💼 Introduction to Accounting Rate of Return (ARR)
This segment introduces the concept of the Accounting Rate of Return (ARR), also known as the Average Rate of Return, as a technique in capital budgeting. The ARR method considers the earnings from an investment over its entire life, focusing on accounting profits. The formula for ARR is presented as the average profit divided by the average investment. The video explains the importance of understanding how to calculate average profit and average investment, which involves accounting for cash inflows, depreciation, and taxes. The process of calculating profits by deducting depreciation and taxes from cash inflows is emphasized, setting the stage for a deeper dive into the ARR technique.
📊 Calculating Average Profit and Investment
The second paragraph delves into the specifics of calculating average profit and average investment. It explains that average profit is derived from total cash inflows minus total depreciation and taxes. The calculation of depreciation is detailed, emphasizing that if there is no scrap value, the entire initial investment is considered for depreciation. The tax calculation is also discussed, highlighting that it should be based on the residual value after depreciation. The process of determining average investment is outlined, which involves averaging the initial investment and scrap value (if any), and adding any additional working capital. The paragraph concludes by demonstrating how to calculate the ARR percentage by dividing the average profit by the average investment and multiplying by 100.
🔢 Practical Application of ARR Calculation
This segment provides a practical example to illustrate the ARR calculation. It walks through a scenario with an initial investment of 1 lakh sixty thousand, no scrap value, and cash inflows for five years. The depreciation is calculated on a straight-line basis over five years, with a tax rate of 40 percent. The process involves summing up the cash inflows, calculating the total depreciation (considering the entire initial investment since there's no scrap value), and then determining the profit after tax. The average profit is then calculated by dividing the total profit by the project's life (five years). The average investment is calculated by taking half of the initial investment, as there's no scrap value or additional working capital. Finally, the ARR is computed by dividing the average profit by the average investment and converting it to a percentage.
📚 Conclusion and Preview of Future Topics
The final paragraph wraps up the discussion on ARR by summarizing the steps involved in calculating it. It reiterates the importance of considering cash inflows, depreciation (especially when there's no scrap value), and taxes in the profit calculation. The paragraph also previews upcoming topics, such as the Net Present Value method, and hints at the possibility of solving combined problems in future videos. The summary serves as a conclusion to the ARR discussion and a teaser for further learning in capital budgeting techniques.
Mindmap
Keywords
💡Investment Decision
💡Payback Period Technique
💡Accounting Rate of Return (ARR)
💡Capital Budgeting
💡Earnings
💡Cash Inflows
💡Depreciation
💡Tax
💡Average Profit
💡Average Investment
💡Net Present Value (NPV)
Highlights
Introduction to the Average Rate of Return (ARR) technique in capital budgeting.
Explanation of how ARR takes into account the earnings from an investment over its entire life.
Description of the ARR formula: Average Profit divided by Average Investment.
How to calculate average profit by dividing total profit by the project's life span.
The process of calculating total cash inflows by adding up all cash inflows over the project's life.
Details on calculating depreciation, especially when there is no scrap value involved.
Clarification on calculating tax based on the residual value after depreciation, not on cash inflows.
The method to determine the Average Investment by using the initial investment and scrap value.
Importance of considering additional working capital in the calculation of average investment.
How to compare ARR percentages of different projects to select the one with the highest return.
The significance of ARR in focusing on accounting profits, hence its alternative name, Accounting Rate of Return.
A step-by-step guide to solving an ARR problem, starting with writing the formula.
Instructions on adding up all cash inflows for the entire life of the project.
The approach to calculating annual depreciation when there is no scrap value.
How to calculate tax on the residual value after accounting for depreciation.
The final steps to determine the average rate of return in percentage form.
Emphasis on the simplicity of the ARR method once the cash inflows, depreciation, and tax are understood.
Preview of the next video covering Net Present Value and the possibility of a combined problem.
Transcripts
hi everyone this is the third video of
investment decision chapter and in the
previous video we have seen the payback
period technique of capital budgeting
right we have seen this payback period
now in this video what are we going to
do is in this video 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 video we are going to see net
present value and if you want we can
also do a combined problem okay
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