hi guys welcome back so we already had a
discussion on the net investment
calculation and the cash flow
calculation under capital budgeting this
time we are going to talk about the
capital budgeting techniques or models
the capital budgeting techniques are
models include the accounting rate of
return the payback period the net
present value the internal rate of
return and the profitability index for
this session we are going to focus on
the accounting rate of return or ARR the
accounting rate of return is the
accounting profit generated by a project
expressed as a percentage of the
investment made in that project the
formula for the ARR is a are R equals 2
accounting profit divided by the net
investment the net investment can mean
the initial investment that is year 0
investment or the average investment
throughout the life of the project to
deal with the calculation of the a or R
let us proceed to the following sample
case a new investment in machinery made
by Jupiter corporation cost 800,000
which is expected to be news for four
years Jew produces the straight-line
method to depreciate assets the cash
flows expected for these projects are as
follows
year one 340 thousand year two 380
thousand year three 380 thousand and
year for three hundred thousand let us
calculate the accounting rate of return
for this project so we are going to
start with the given before it acts cash
flows per year that's before tax cash
flows for year one two three and four we
have the following given that's three
hundred forty thousand in year one
380,000 in year two three hundred eighty
thousand in year three and three hundred
thousand in year four so what is given
to us is a before tax cash flows
remember that accounting rate of return
is the only method to evaluate our
projects decidability that utilizes net
income instead of cash flows as such
we're going to make some adjustments to
arrive at the profit figure we need to
the dock the depreciation expense per
year we have depreciation expense the
project would last for four years and it
costs 800 thousand using the straight
line method you have eight hundred
thousand divided by four
that would be two hundred thousands or
year
we are going to have the following
profit fingers 140-thousand ear one
180-thousand both for year two and three
and 100,000 for year four
these are the profits for each year
since we have different profit figures
for each year we just need to take the
average of the four taking the average
of this four we are going to have an
average annual profit of one hundred
fifty thousand pesos let us now
calculate the accounting rate of return
so you will have a or or this is equal
to profit over investment one version of
the or R would utilize the initial
investment as our denominator we're
going to use that first you have a
profit of 150 thousand aveer divided by
the investment of eight hundred thousand
this would give us a paean point seventy
five percent the accounting rate of
return based on initial investment the
second version of the ARR is one that is
based on the average investment so if
the initial investment is eight hundred
thousand and at the end of the project's
life it would be fully depreciated well
we would have eight hundred thousand
plus zero divided by 2 that's an average
investment of 400 Thaksin so we would
have an a or art based on the average
investment this is equal to 150 thousand
and again the average of eight hundred
thousand in the beginning and presumed
to be zero the salvage value at the end
of the project life
that is an average of 400,000 150
divided by 400,000
this is 37.5% the accounting rate of
return is very intuitive it's very easy
to understand well for any given amount
of investment what percentage will go
into profits that is what we found in
rate of dr. limited means however it
suffers two major drawbacks number one
it is based on accounting profit instead
of cash flows we already had a full
discussion on this in the previous
session cash flows are a better
indicator of performance compared to
profits number two it does not account
for the time value of money as a result
of these two drawbacks we can say that
the accounting rate of return is the
business of all capital budgeting models
despite that is in understanding this is
still the weakest model it is in my
opinion that we should use the
accounting rate of return only for
purposes of evaluating the impact of the
project on the financial statement
ratios especially return on asset and
return on equity but other than that to
really use as a basis for decision
making
accounting rate of return is a weak tool
for such purposes let us now proceed to
the next capital budgeting technique we
have the payback period unlike a housing
rate of return the payback period would
utilize cash flows together with other
capital budgeting models payback period
this is the time period needed to
recover the investment it is a measure
of a project's liquidity
that is the ability of the project to be
back to cash or cash convertibility for
the calculation of the payback period as
well as the interpretation let us
proceed to the next sample case a new
purchase of machine to be made by Mars
MA corporation cost 500,000 which is
expected to be in use for four years
Mars my uses the straight-line method to
depreciate assets the profits to be
earned from this machine are as follows
year 1 100,000 year to 130,000 year 3
75,000 and year for 65,000 so let us
consider the profits that's expected to
be earned
every year one hundred thousand one
thirty thousand seventy five thousand
and sixty five thousand when calculating
the payback period we are actually not
interested with profits again all other
models would utilize cash flows we want
to know how long would it take for an
investment that we have made to be
recovered back in the form of a she
that's what the payback period is all
about
so rather than rely on the profit
figures we are going to use the cash
flows so remember if what is given is a
profit just add back the non-cash
expense yes
that's depreciation so let us calculate
the depreciation to be added back the
profits in order to arrive at the cash
flows we have a cost of investment of
$500,000 well four years that would be
five hundred thousand divided by four so
every year the depreciation ex
is around 125,000
so we will have the following cash flows
every year your one that would be
225,000 year - that's two hundred fifty
five thousand you three that will be two
hundred thousand and your four we have
one hundred ninety thousand so what's
the payback period the payback period is
the time period needed to recover the
investment so we are going to analyze
this one year at a time so when we have
an investment of five hundred thousand
this is the year 0 outflow in year 1 we
are expected to generate two to five
Thompson this is the cash flows that
would be generated in that year so
that's five hundred thousand less
225,000 well at the end of the first
year we still have two hundred
seventy-five thousand and recover
so one year is not enough to recover the
investment let's go to year 2 in year 2
it's expected to generate two hundred
fifty five thousand by the end of year
two we would have still and recovered
cash flows of twenty
now there's 20,000 more to the cover if
we're going to spend another year that's
here three were expected to generate
200,000 this is more than enough this is
more than enough time to look over the
investment so we do not need three years
what we would need would be two years
plus a fraction over here we are going
to make an assumption we're going to
make an assumption that the cash flows
generated in one year are evenly
distributed throughout that entire year
it is generated evenly throughout the
year so for this 200,000 in year T we
can assume that every day we are going
to have one over 365 of this amount in
such a case we do not need three years
we only need two years plus enough time
to recover only 20,000 so if we need
20,000 and in this year we will generate
200,000 we only need point 1 of that
year so the payback period is 2.1 years
what does this figure mean this figure
simply means from the time of investment
it would take 2.1 years to recover that
amount of investment does it say
anything about the project's
profitability no it doesn't say anything
about whether this project is going to
very nice or it will give us losses it
doesn't say anything but simply tells us
is that it would take 2.1 years to
recover the investment amount what we
have calculated is the traditional paper
value
there are also other variants of the
Biba billion this includes the bailout
billion this assumes that the project is
terminated if all invested cash flows
are recoverable in that case we're going
to consider the salvage value if
applicable to we also have the
discounted payback period
these are hounds for the time value of
money in calculating the payback period
in such case we would need present value
factors now the payback period is
actually a good tool in measuring
liquidity that is again a cash
convertibility of the project however it
suffers the following drawbacks it
ignores the time value of money with the
exception of the discounted payback
period Valiant
payback period ignores the fine value of
money actually it's both payback and
bailout period and aside from that as
mentioned a while ago it ignores the
profitability of the project it just
tells us how long it would take to
recover the project but it doesn't tell
us whether the project is profitable now
how are we going to evaluate the payback
period
well we want a shorter payback period we
want to quickly recover the cash
investment so to evaluate using the
payback period we would want a payback
period as short as possible the shorter
the payback period the better in the
next video we are going to talk about
the discounted cash flow techniques
these are the techniques that would
account for the time value of money
until then like share and subscribe