Capital Budgeting Techniques – Using ARR to Determine Investment

shutterstock_127978619An organization’s primary goal is to make a profit. Budgeting is an essential skill for any financial manager or entrepreneur. As the old adage goes, failing to plan is planning to fail, and creating a budget is essentially creating a plan for your business success. Decisions regarding how a company should spend its capital can be one of the most important decisions an entrepreneur has to make. Capital investment and capital expenditure generally forms a large portion of initial outlay, as well as influencing the productivity and efficiency of a business. For more information on how to raise capital for your new venture, enroll in the the How to Raise Startup Capital course. This course offers thirty lectures that will teach you what venture capitalists, angels, friends and family are looking for in terms of investment returns and criteria. You will learn when to approach these groups of people to raise finance. You will also learn the pros and cons of each type of finance and you will be able to approach each group to raise funds for your venture without spending time on low probability funding sources.

There are a number of capital budgeting techniques that can be used to determine the viability and profitability of capital budget and investment decisions. These techniques include:

·         The Accounting Rate of Return Method

·         The Payback Period Method

·         The Net Present Value Method

·         The Profitability Index Method

·         The Internal Rate of Return Method

The most important thing to remember about capital budgeting techniques is that these techniques are merely ways to determine whether a particular investment will be profitable for the organization in the end. For the purposes of this article, we will use an example to illustrate how the ARR method of capital budgeting works.

Example

A manager has to decide whether the company should purchase a new machine. The machine will cost $100 000 and the machine’s estimated lifespan is expected to be three years. The company has determined the scrap value of the machine to be $10 000 at the end of this period. The machine is expected to generate a total of $18 000 in profit in the first year, $20 000 in the second year and $ 22 000 in the third year. The company employs the straight-line method to calculate the depreciation of its assets.

Let us examine the ARR method of capital budgeting to see how it could help to determine whether the manager should make the investment or not.

The Accounting Rate of Return Method

The first method we will examine is the Accounting Rate of Return or ARR method of capital budgeting. The ARR capital budgeting technique is one of the most widely used budgeting techniques. This method is also known as the Average Rate of Return method and it calculates what return the investment will generate in terms of net income to the organization over the lifespan of the investment. This method represents the return as a percentage of the original investment.

Organizations often require a minimum amount of return for a capital investment before they will consider investing in that asset. Calculating the return based on the ARR method therefore provides management with a precise indication of whether they should invest in the asset or not.

There are two ways to calculate the ARR of an investment. We will look at both formulas. The first formula involves depreciation. If you are new to accounting and would like to learn the basics, then join the hundreds of students who have signed up for the Introductory Financial Accounting course. This course includes over fifty lessons that will teach you all about the accounting cycle and how to cost inventory. It will teach you about the various financial statements including the Income Statement, Balance Sheet and Statement of Cash Flows. It also includes lessons on Fixed Asset accounting as well as depreciation.

ARR Calculated Using the First Formula

The first formula can be expressed as:

Capital1

Where:

  • Average Annual Profit is calculated by working out the annual cash inflow generated by the project minus depreciation.
  • Initial Investment is equal to the investment required for the project.

This formula therefore requires us to calculate the depreciation of the asset, as well as calculating the cash flow generated by the project. The formula for depreciation can be expressed as:

Capital2

Take a look at the Excel spreadsheet below:

Capital3

The numbers in blue are the ones we were given in the original example. To calculate ARR using method one, we first need to calculate depreciation which is calculated by subtracting the scrap value ($10 000) from the machine cost ($100 000) and then dividing the answer by the lifespan of the machine therefore:

$100 000 – $10 000 / 3 = $30 000.00

The Average Annual profit is determined by adding the forecasted profit figures together and then subtracting the depreciation, so:

$18000.00 +$20 000.00 +$22 000.00 – $30 000.00 = $30 000.00

The initial investment in the machine was $100 000.00 so now we can calculate the ARR by dividing the annual average profit by the initial investment:

$ 30 000.00 / $ 100 000.00 = 30%

The ARR of this investment would therefore work out to thirty percent. Assuming the company insisted on a minimum ARR of ten percent, the manager of the company would therefore conclude that this investment is one which would be profitable for the organization.

Formula Two for Calculating ARR

The second formula for the calculation of ARR is a little simpler than the first since the formula does not include depreciation. The formula can be expressed as follows:

Capital4

Where:

Average Investment value is the initial cost of the asset plus the scrap value of the machinery divided by two.

Capital5

 

The Average Investment value is therefore $ 100 000.00 + $10 000.00 divided by 2 which equals $55 000.00.

The Average Annual Profit is calculated by adding the profit over three years and dividing by three:

$18 000.00 +$20 000.00+$22 000.00 / 3 = $ 20 000.00

As you can see from the above, the two values of ARR are different and the difference between these values can be relatively large depending on the values and profits involved. The ARR does however provide a simple and straightforward way of determining the profitability of a particular investment and can also be used to compare two different investments to calculate which investment offers a better rate of return.

Disadvantages of the ARR

One of the biggest disadvantages of using ARR to calculate profitability is the fact that ARR does not take the time value of money into account. The value of money today is not the same as the value of money at a later period of time. Another disadvantage of using ARR as a capital budgeting technique is because there are two formulas linked to this capital budgeting method.

To learn about other capital budgeting techniques and to take your accounting skills to the next level, sign up for the How to Budget and Forecast for Your Business course today. This course offers over thirty lectures that will teach you the difference between start up and ongoing expenses. It will explain how expenses and assets are treated for tax purposes. It will teach you how to create an accurate sales forecast for your business as well as showing you how to create an expense budget. It will teach you the important difference between profits and cash and provides a number of online resources to help you answer any tax questions you may have.