example of accounting rate of return

Question

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 1^st 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.