From an economic point of view, businesses are seen as entities that raise capital through various channels (often with the help of financial intermediaries, e.g., investment banks) and use this capital to make investments. Those funds are often used to buy properties, plants, and necessary equipment and resources to increase productivity, innovation and thus increase profitability, which is the ultimate objective of any business operation. Investment decisions tend to have a thorough analysis because it usually involves a large amount of money, or acquiring capital assets requires relatively long-time scales. Besides, it is often challenging and/or costly to retreat from an investment once it has been made (Atrill & McLaney, 2018), so the management must take cautious and elaborate actions when considering long-term investments. Insufficient consideration of various factors and lack of investment appraisal techniques may eventually result in a firm’s prosperity on a short and long-term basis. A few sources and industry-leading authors define capital expenditure in the literature, also known as capital budgeting or investment appraisal.
Capital budgeting is a process of planning to invest in long-term assets in a way that returns the most profitability to the company.
Miller-Nobles, et al. 2018
Capital expenditure is the process in which a business determines whether projects such as
building a new plant or investing in a long-term venture are worth pursuing.
Aversano, 2016
According to Atrill & McLaney (2018), research suggests that four main appraisal methods are used by businesses to assess the feasibility of investment opportunities. Those techniques can be utilized individually or together to varying degrees, depending on the type of investment.
I. Accounting Rate of Return (ARR)
II. Payback Period (PP)
III. Net Present Value (NPV)
IV. Internal Rate of Return (IRR)
Accounting Rate of Return (ARR)
The accounting rate of return (ARR) is a relatively easy and quick method that is specifically beneficial for investments with a short life span, such as computer equipment and software with a useful life of three to five years (Horngren et al. 2017), but it is not limited to and can be used for a variety of investments. ACCA Global describes ARR as the return on investment, gives the annual accounting profits arising from an investment as a percentage of the investment made. So ARR measures the profitability of an investment. The formula for calculating the ARR is as follows:
It is important to note that ARR considers profits not the cash flows, thus an average annual operating income and the amount of investment must be calculated beforehand to receive the ARR. To calculate the first, a few information are needed:
I. Total net cash inflows during operating life of the asset. Annual operating income otherwise known as net cash inflows must be acquired.
II. Total depreciation.
III. Life of the project (life span).
Figure 1.1. A brief to illustrate ARR in practice. Retrieved from www.accaglobal.com
Step 1: Calculate average annual operating profit: total profit / number of years.
Cash inflows year 1 & 2 $30,000
Cash inflows year 3 & 4 $10,000
Cash inflow year 5 $35,000
Depreciation ($35,000)
Total profit $40,000
Therefore, an average annual operating profit for this investment is $8,000 ($40,000 divided by 5 years of its life span).
Step 2: Calculate an average amount invested:
The denominator of the ARR formula can be either presented as the initial investment or
as the average investment, which can be calculated as follows:
Average investment = (initial investment + scrap value) / 2AI = ($40,000 + $5000) / 2 = $22,500
ARR: 8000/22500 x 100% = 36%
Reading the outcome
If the ARR is equal to 5%, this means that the project is expected to earn five cents for every dollar invested per year (Corporate Finance Institute, n.d.). In our case, the company would make 36 cents (equals 36%) for every dollar invested every year.
Advantages of using Accounting Rate of Return
ARR is an easy method to implement, and companies often use it as an investment appraisal technique. The manager of an organisation can easily understand the concept, which can assist them with the final decision. This method tends to emphasise the return on investment for the whole duration of the project as the ARR measures the investment's profitability.
Disadvantages of using Accounting Rate of Return
One of the biggest disadvantages of the ARR is that it does not take cash flows into account. Any profitable organisation can get into serious problems if they do not have enough cash to meet their short-term liabilities, even though they are profitable in the long run. Depending on the size and type of an investment, the ARR itself may not be sufficient to determine the investment's feasibility and whether the company can actually afford it.
Bibliography:
ACCA Global (2020). Accounting Rate of Return [online]. Available at
https://ereader.perlego.com/1/book/811392/400 [Last accessed on 01 December 2020]
Accounting Explanation (2011). Qualitative Considerations in Capital Investment Analysis
[online]. Available at http://www.accountingexplanation.com/qualitative_considerations_
in_capital_investment_analysis.html [Last accessed on 03 December 2020]
Atrill, P. McLaney, E. (2018). Accounting and Finance: An Introduction 9th edition. 9th ed.
[ebook] Pearson. Available at: https://www.perlego.com/book/811392/accounting-and-finance-an-introduction-9th-edition-pdf
Atrill, P. and McLaney, E. (2018). Management Accounting for Decision Makers 9th edition. 9th ed. Pearson: London.
Aversano N. (2016). Global Encyclopedia of Public Administration, Public Policy, and Governance. Springer. Capital Budgeting. Cham. https://doi.org/10.1007/978-3-319-31816-5_2328-1
Yorumlar