Question

1. A machine costs Rs. 10,000 with useful life of 5 years. It has a salvage value of Rs. 2,000 at the end of its useful life. The machine is expected to generate the following cash flows;

Year	Cash Flow (PKR)
1	5,000
2	6,000
3	8,000
4	6,500
5	4,000

Calculate Accounting Rate of Return? Tax is applied at 30% per annum. Why Accounting Rate of Return is not among the favorite methodology to evaluate a project? In what circumstances results from accounting rate of return can prove useful.

Answer 1

Average Cash Flow = Sum of All Cash Flow / No of Years

= (5000 + 6000 + 8000 + 6500 + 4000) / 05

= 29,500 / 05 = 5900

Machine Purchase Cost = 10,000

Salvage Value = 2000

Depreciation each Year = ( Machine Purchase Cost - Salvage Value) / 05

= ( 10,000 - 2,000) / 05

= 1600

Accounting Rate of Return = ( Average Cash Flow - Depreciation each Year ) / Initial Investment

= ( 5900 - 1600) / 10,000

= 4300 / 10,000 = 43%

Accounting Rate of return = 43% (Ans)

Why Accounting Rate of Return is not among the favorite methodology to evaluate a project : Because ARR (Accounting rate of return) does not consider time value of Money unlike NPV Method. Also it excludes Tax proceeds when calculating return.

In what circumstances results from accounting rate of return can prove useful: When a project consist of multiple sub projects and investments and cash flow in each are different ARR methodology may be useful.