Understanding the Accounting Rate of Return (Essay Sample)

FINANCE AND PROJECT MANAGEMENT
Student name
Instructor’s name
PGBM134
Date due
PART A
Return on capital employed

12%

 

 

 

 

 

 






 

 






 

 






 

Year

Project X (£)

PV of the Cashflow

Payback period

Project Y (£)

PV of Cashflow

Payback period

0

-£ 110,000.00

-£ 110,000.00

-£ 110,000.00

-£ 200,000.00

-£ 200,000.00

-£ 200,000.00

1

£ 45,000.00

£ 40,178.57

-£ 65,000.00

£ 50,000.00

£ 44,642.86

-£ 150,000.00

2

£ 45,000.00

£ 35,873.72

-£ 20,000.00

£ 50,000.00

£ 39,859.69

-£ 100,000.00

3

£ 30,000.00

£ 21,353.41

£ 10,000.00

£ 50,000.00

£ 35,589.01

-£ 50,000.00

4

£ 30,000.00

£ 19,065.54

£ 40,000.00

£ 100,000.00

£ 63,551.81

£ 50,000.00

5

£ 20,000.00

£ 11,348.54

£ 60,000.00

£ 55,000.00

£ 31,208.48

£ 105,000.00

Payback



2.33



3.5

NPV

 

£ 17,819.78

 

 

£ 14,851.85

 

Table 1: NPV and Payback period
Payback period
The payback period is a crucial investment appraisal method used to determine the time taken to recoup the capital employed in a project. The investment appraisal method has gained popularity in capital budgeting due to its simplicity and reliability while evaluating projects. The method is quite straightforward for any project manager to know and understand. Its application in projects serves to mitigate the risks of losing funds injected into a project. Projects with a long payback period tend to be riskier than a project with less year of payback. The investment appraisal method approaches capital budgeting by calculating the present values of the cash flow of the project. It continues adding the cash flows from the subsequent year, as shown in table 1.
The decision criterion is that the shorter the project period to gain the amount of funds invested, the better the project. Projects with a shorter period of payback should be prioritized over projects with a longer period. In the above analysis, Project X takes 2.33 years to recover the initial investment, while Project Y takes 3.5 years to recover the amount invested. According to the Payback period, project X is a viable investment to undertake due to its short period of recovering initial capital outlay. However, there are few concerns regarding the investment appraisal method. The payback period disregards any cash flow that comes after the payback period. In this case, it is not suitable for a project with high value after long periods. In some cases, some viable investment projects have high cash flows beyond ten years; thus, managers ought to understand the project scope and any other detail.
The accounting rate of return
Accounting Rate of Return

Project X (£)

Project Y (£)

Total net cash flows

£ 170,000.00

£ 305,000.00

Total Depreciation

£ 110,000.00

£ 200,000.00

Project Years

5

5

average accounting profits

£ 12,000.00

£ 21,000.00

average capital employed

£ 110,000.00

£ 200,000.00

ARR

10.91%

10.50%

Table 2: Accounting Rate of Return
The accounting rate of return is calculated by dividing the average accounting profit by the average capital employed. The investment appraisal method puts into consideration the depreciation, net cash flows, and project years. The table above shows the detailed computation of value from the scenario. The net cash flow for project X was $170000, while project Y had $305000. The project deprecation was computed through straight-line depreciation. For example, at the end of five years, the residual; value was zero, meaning the total deprecation is equal to the total initial capital outlay. In addition, both projects would run for five years. Therefore, the average accounting profits for projects X and Y were 12,000.00 and 21,000.00, respectively. The average capital employed was 22000 and 40000, which translates to an Accounting rate of return of 10.91% from project X and 10.50% for project Y. The decision criteria in the investment appraisal method are that a project with a high accounting rate of return is viable compared to a project with a lower Accounting rate of return. Therefore, project X is feasible than Project Y; KK Smith & Sons plc should undertake Project X.
The accounting rate of return is notably a good measure of investment viability. The method is quite simple thus easy to compute. It is necessary when there is a need for a quick evaluation of the projects. The key distinguishing feature between the payback period and accounting rate of return is its regard for the concept of the net project by considering depreciation and taxation. However, there are a few concerns which finance managers need to be aware of while evaluating the project using this method. It does not put into consideration the time value of money. In any investment, the time taken accumulates the interest rate, which should be an important factor while evaluating a project over a certain duration. Another major issue is the assumption of a short period of investment. The investment appraisal method analyses return based on average return, which could vary or remain the same over time. The method disregards the periodical changes in the returns of an investment.
Net present value method of investment appraisal
Net present value is another very critical method of investment appraisal. The method is very suitable for the evaluation of a series of cash flows from an investment. The method uses an approach of determining the present value of cash flows from a different time. The cash flows are subjected to a return rate from capital employed or discount rate. In this case, in table 1, projects X and Y used a discount rate of 12%. Project X's resulting net present value is 17,819.78, while project Y had a Net present value of 14,851.85. The decision rule for the net present value is that accept a project with a positive NPV if you are dealing with one project, but If one is dealing with multiple projects, then compare the value of the NPV. A project with net present value is viable compared to the projects with lower Net present value. The best project, in this case, will be project X due to the high Net present value of 17,819.78
Net present value method problem and mitigation strategy
Net present value is one of the best methods of investment appraisal. The superiority of the method is attributed to its regard for the time value of money. The method considers the time value of money, which is a distinguishing feature from the payback period and the accounting rate of return, thus more accurate. In addition, the method is more suitable to project of the same size. The financial managers may compare projects of similar size and make a well-informed decision on the most viable project. The decisions making based on NPV is also accompanied by the judgment of the profitability of their project. The profits or losses from a...