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.