# Understanding the Accounting Rate of Return (Essay Sample)

PGBM134 Finance and Project Management

Individual assignment

Weighting – 100% of the marks for this module

This is an individual assignment of 4,000 words. The wordcount is for guidance only.

The hand in date is: October 2021 (to be confirmed)

Students are required to submit their coursework through Turnitin. Only assessments submitted through Turnitin will be marked. Any other submission including submission to your study centre in hard copy will be treated as a non-submission.

If your centre supports Turnitin©, a copy of your Turnitin© originality report must be submitted in conjunction with your assignment.

Requirements:

Part A of the assessment is compulsory for all students with a marking allocation of 50% awarded within this element.

Part B of the assessment is compulsory for all students with a marking allocation of 50% awarded within this element.

The assignment has been designed to cover the following learning outcomes associated with successful completion of the module:

Knowledge

K1. Critical understanding of the key strategic decisions that a business may have to make and appreciated how accounting and finance can assist in making and evaluating those decisions.

K2. Critical understanding of specific analytical skills in key decision areas within strategy and finance relating to Ratios and Investment Projects.

K3. That they can appreciate the requirements for management control and the application of project control processes

K4. A critical understanding of the relationship between, cost and quality in achieving project objectives

Skills

S1. Competence in applying the key valuation concepts and methodologies of financial decision making in order to contribute to the wider decision making of the organisation

S2. Their capability to evaluate projects from a financial, human resource and time related perspective

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...

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