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Learning Objectives of this
article:
-
Define and explain the average
rate of return method.
-
How is average rate of return
calculated?
-
What are its advantages and
disadvantages?
Contents:
Average rate of return is a method
of evaluating capital investment proposals
that measures the expected profitability of an
investment in plant assets. This method
is also known as accounting rate of return
method. Average rate of return method
is one of the methods of evaluating capital investment
proposals that does not consider present values.
Following formula is used to
calculate average rate of return:
|
Average rate of return =
Average annual incremental income / Average
investment |
The numerator (average annual
incremental income) and denominator (average
investment) in the above formula are now explained
below:
Average Annual Incremental Income:
The expected average incremental
income to be earned is equal to the sum of
incremental income over the project life divided by
the project life. The annual incremental income can
be calculated for revenue enhancing projects or cost
reduction projects. When this formula is used for
revenue enhancing projects, the annual incremental
income is calculated using the following equation:
Incremental income = Incremental
revenue - Incremental cost including depreciation
from investment
When the formula is used for cost reduction
projects the annual incremental income is calculated
as follows:
Incremental income = Incremental
revenue - Incremental cost including depreciation
from investment
Sometime return from investment may be expressed
as annual cash flows. We must subtract depreciation
when return from investment is expressed as annual
cash flows. For example, If an investment costing
$50,000 has a five years life and no salvage value,
generated annual cash flows of $20,000. The average
incremental annual income would be:
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Average Annual incremental
income = $20,000 - ($50,000/5)
= $20,000 - $10,000
= $10,000 |
Average Investment:
The average investment (denominator
in the average rate of return formula) can be either
the original cost of the asset or the average
investment in the plant asset. The average
investment is the midpoint of the depreciable cost
of the plant asset. The midpoint is equal to the
original cost plus residual value of the asset
divided by 2.
Management wants to purchase a
machine. The machine can replace six workers whose
average annual wages and benefits total $300,000 per
year. The cost of machine is $500,000 and it is
estimated that the annual cost to operate the
machine will be $134,000. The expected useful life
of the machine is 4 years and expected salvage value
is $60,000.
Should management purchase the
machine? Use average rate of return method
(accounting rate of return method) to evaluate this
investment proposal.
Solution:
The estimated average annual income
is determined as a cost reduction project as
follows:
| Total annual labor
savings |
|
$300,000 |
| Less: annual operating
cost |
$134,000 |
|
| Annual straight-line
depreciation ($440,000/4
years) |
110,000 |
244,000 |
| |
|
|
| Average annual
incremental income |
|
$56,000 |
| |
|
|
| The average
investment is $280,000
[($500,000 + $60,000
residual value) / 2]. Thus,
the expected average rate of
return on the average
investment is 20%, computed
as follows:
Average rate of return =
Estimated average annual
incremental income / Average
investment
= $56,000
/ $280,000*
= 20%
*
($500,000 + $60,000) / 2
The expected average rate
of return is compared with
the rate of return set by
the management. The machine
is desirable if the expected
rate of return (20%) exceeds
the minimum rate set by the
management. |
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Management can rank different
alternative proposals by their average rates of
return. The proposal with the highest average rate
of return is considered to be the most desirable.
For further clarification consider the following
example:
Example
Management is considering the
following alternative capital investment proposals and has the
indicated average rates of return:
| |
Proposal A |
Proposal B |
| Estimated
average annual incremental
income |
$30,000 |
$36,000 |
| Average
investment |
$120,000 |
$180,000 |
| Average rate
of return: |
|
|
|
$30,000 / $120,000 |
25% |
|
|
$36,000 / $180,000 |
|
20% |
| If only the
average rate of return is
considered, Proposal A, with
an average rate of return of
25%, would be preferred over
Proposal B |
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Advantages:
This method of evaluating capital
investment has the following main advantages:
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It is easy to compute.
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It includes the amount of income
earned over the entire life of the proposal.
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It emphasizes accounting income,
which is commonly used by investors and
creditors in evaluating management performance.
Disadvantages:
The main disadvantage of average
rate of return method (accounting rate of return
method) is that it does not directly consider the
expected cash flows from the proposal and the timing
of the cash flows. The cash flows and its timing is
very important because cash coming from investment
can be reinvested in other income generating
activities.
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