Example of accounting rate of return method, Finance Basics

Example of Accounting Rate of Return Method

                                   Shs.

Project X cost              500,000

Scrap value                 100,000

Stream of income before when depreciation and taxes are follows as:

                         Shs.

Year 1              100,000

Year 2              120,000

Year 3              140,000

Year 4              160,000

Year 5              200,000

Let tax = 50% and depreciation straight line. Compute the accounting rate of return.

Solution

Depreciation   =          (500,000 - 100,000)/ 5 years

                     =          Shs.80, 000

Year

1

2

3

4

5

Income

Less depreciation

Earnings before tax EBT

Less tax @ 50%

EAT

100,000

  80,000

20,000

(10,000)

10,000

120,000

  80,000

40,000

(20,000)

20,000

140,000

  80,000

50,000

(30,000)

30,000

160,000

  80,000

80,000

(40,000)

40,000

200,000

  80,000

120,000

(60,000)

60,000

Average income (EAT)   = 32,000

Average investment       = (500,000 + 100,000) ½   =          300,000

Or ARR = (Average income / Average investment) x 100 =  32,000 /300,000 x 100 = 10.67%

Note   

The method of depreciation to use should be that which will generate larger depreciation alterations in the 1st few years of the assets life and lesser changes in the later years since this will generate a higher tax shield to the company along with higher value of inflows.  So reducing balance is preferred as compared to sum of digits and straight line method.

Posted Date: 1/30/2013 5:09:46 AM | Location : United States







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