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“And welcome to the session in which we would we would keep working with chapter chapter 9. It s about net present value and other investment criteria. The other investment that we re going to be using today is average accounting return or for short aar average accounting return well it s an attractive but flawed approach of making capital budgeting decision. So you re saying if it s a flawed.
Where are we discussing it well we re gonna look at our investments from different perspective. And one of it is an accounting perspective accounting. Means. What accounting means.
It s gonna be from a an accrual revenue and expense perspective not cash. It s accounting and that s one of its flawed. It s it doesn t use cash cash. What matters.
It s gonna be using accounting. So the first problem with it it doesn t use cash but we re gonna look at it and then we re gonna know what average accounting return is there are many different definition of average accounting return. However it s in one form of another it s taken some measure of profit in the numerator divided by some measure of average accounting value. So the definition is basically what it boils down to is you ll take the average net income divided by the average book value so this is the general definition so we re gonna we re gonna come up with some numbers.
But basically what you re looking for is what s your average income for that period of time let s assume. It s 100 and your book value is a thousand average book value so your accounting rate of return is 10. So this is basically mechanically how it s calculated. But the best way to do this is to actually what you need a complete example to see how we actually calculate this number.
Then we will discuss the pros and the cons of this method just to see how we might calculate this number. So suppose we are trying to open deciding to open a store and a shopping mall. So that s that s our project. The required investment and the an improvement is half a million.
So we have to spend half a million dollar in improvement in the store. So the store would have a five year life. Because of thing reversed to the more mall owners. After that time so.
The project is five years. The required investment will be 100 depreciated over five years so basically simply put we re gonna invest half a million what can a depreciated over five years therefore every year we re gonna expense 100000 in depreciation the tax rate is 25 so we re gonna be paying on our earnings 25. So now table 9 4..
Contains the projected revenues and expenses and net income in each year. Based on these figures is also shown so here s what what what our life is gonna look like for the next 5 years from an accounting perspective year. One revenue is four hundred thirty three thousand 333. This is basically given so this these numbers are given expenses.
Two hundred thousand given earnings before depreciation to thirty three thousand to thirty to thirty three 333 depreciation is already calculated to be 100000 per year earnings. Before taxes is one 33333 taxes of twenty five percent taxes is 33333 therefore net income is one hundred thousand so now you re wondering why they gave you two revenue as four hundred thirty three thousand 333 so at the end. We have a nice rounded number of a hundred thousand year. This is the revenue.
These are the expenses depreciation is the same then taxes is 25 percent. We have a net income of one hundred and fifty thousand year three. We re gonna have a net income of fifty thousand based on our revenues and expenses here for we re gonna break even and year five. We re gonna incur a loss okay so those are the five years for the project so this is gonna be our numerator so on the numerator.
We re gonna have to put our average net income and what s our average net income. Just basically take our net income for five years and divide them by five and that s going to give us an average net income of 50000. So this is basically average net income now. What is the average book value well we re gonna start with a half a million dollar investment.
Then we re gonna end up with zero investment why zero. Because it s gonna be fully depreciated therefore. Five hundred thousand plus zero divided by 2 equal to 250. So this is the book value now.
It s easy all i have to do take 50 thousand. An income divided by the book value of two average book value divided by 250 so to calculate the average book value. We know that we started with a half a million and then that was zero y zero. Because it s fully depreciated so the average book value so what s the book value well we need just in case.
You don t know what the book value is it s the cost minus accumulated depreciation equal to the bv book value. The cost of the asset is half a million and over a period of five years. Every year we add 100000. And.
Depreciation. So. 100000..
100000. 100000. 100000 and. 100000.
We have half a million of the appreciation therefore. The book value is zero at the end of the period. Okay. It s just in case.
You re wondering why did we use zero here because the book value is zero and the amperage net. Income we already calculated is 50000. Therefore the accounting at the average accounting return is twenty percent okay so so now we have twenty percent how are we gonna use this information. How good is it okay if the firm has a target average accounting return of 20 then we accept the project so if the company says this is how we charge our project using the average accounting return and we don t accept anything less than twenty then this project is acceptable well.
If the if the target is like let s assume. 25. Then they will not accept the project. Okay based on the average accounting return rule the project is acceptable if it s if the average accounting return exceeds the target average accounting return but the first thing you re gonna say who sets the average accounting greater the target who sets the target.
The company sets the target. How did they set the target. It s an arbitrary figure. So this is again as good as we re discussing this yet you re seeing the the the flaws in the average accounting return okay.
What s another flaw you already maybe noticed it ignores the time value of money. So you should recognize. The chief drawback of the aar immediately the aar is is not a rate of return in any meaningful economic sense. And said.
It s a ratio of two accounting numbers. So it s and it s not computable to the return offered in a financial market shaken up you cannot compare your accounting versus. Some market figure because the market is totally different than how you calculate your net income that income is based on rules set up by gaap. Which is totally different than what the market is suggesting one one of the reasons.
One of the reasons. The arr is not the true rate of return is that it ignores the time value of money so that s another disadvantage. It ignores the time value of money when we average figures that occur at different times..
We are treating the near future and the more distance is the same which is we know that s not true we know we know that this if we look at our net. Income here this. 100000 is different than this 50000. And this 150 is different then this negative 50.
Because they occur at different times. Although they re different amounts as is but also they occur at different amount so that s that s important to remember. And there is no discounting involved when computing the average net income. So we re just looking at net income without taking into account the time value of money.
Another problem is is the similar to the payback period. Concerning the lack of an objective cutoff period. Remember and the payback. We did who sets the cutoff period that the management.
How do they do it arbitrarily. Okay also they calculated a a ar is really not comparable to a market return and the target ar are must somehow be specified. There s no generally agreed upon way to do this one way is to calculate the ar. A ar for the firm as a whole and use this as a benchmark.
But there s a lot of other ways of doing this but even if you calculate the aaa art for the whole firm. The firm. The overall firm may be different than its separate component. May be one division will have a high a ar and others will have a low a ar.
So that s also that s a flawed method of doing things the third and perhaps the worst flaw. And it doesn t look into the right things. And what s the right thing to look at we don t care about accounting numbers. Accounting numbers are meaningless to the investors.
What the investors are interested in is cashflow. Now obviously we can take the accounting numbers and convert them into a cash flow. That s that s one way to do this. But we want to make sure that we are using accounting numbers.
Which is flawed compared to cash flow. It uses net income and book value. Which is not these are poor substitute for cash as a result..
The aar does not tell us what s the effect on the share price that will be taken into the investment. Okay. So that s the irr have any redeeming feature about about the only one is that it almost always can be computed. But of course because it s accounting numbers you could use estimates.
The reason is that accounting information will almost always be available both the project under consideration and for the firm as a whole okay so and we could all always convert cash accounting to cash flow. So what we can do is we can start with the accounting numbers then convert them into cash flow. And there s you know if you re an accountant. That s easy to do so.
That s that s a good feature in it. So. What are the advantages of the aar. A couple advantages easy to calculate needed information will usually be available.
Because it s accounting information. What is the disadvantage not a true rate of return. The time value of money is ignored use an arbitrary cutoff date. Or end five years as a cutoff date.
And also the aar is arbitrary based on accounting figures. Not cash figures in market values and those are the disadvantages so it s not you know it s one way to look at things. But it s an accounting way of looking at things and if you know accounting. There s so many ways to arrive the net income because you have so many different rules that you could utilize to calculate net income therefore outsets it s a flawed method of measuring capital budgeting decision okay the next topic we re going to look at is in this product in this chapter which is chapter 9.
I believe it s the internal rate of return. So the next. The next topic will be the irr. The internal rate of return.
Yes and we re not going to look at it. And just gonna give you an idea. What is the irr. The internal rate of return if you have any questions by all means email me.
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