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

Summary

This 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.