This exercise illustrates the computation of accounting rate of return (ARR) when a projects cash flows are uneven.
A project requiring an initial cost of $650,000 is expected to generate the following cash flows over its 6-years life:
The project does not require any cash expenses. Depreciation is to be provided using a general straight line method. According to firm’s accounting policies, the salvage value is treated as the reduction in depreciable basis.
Required: Compute the project’s accounting rate of return (ARR) from above information.
Step 1 – Computation of annual depreciation expenses:
(Cost – salvage value)/life of the asset
= ($650,000 – $20,000)/6
Step 2 – Computation of average incremental annual income:
Average income = (45,000 + 115,000 + 195,000 + 145,000 + 75,000 + 7,000)/6
Step 3 – Computation of accounting rate of return (ARR):
If initial investment is used as denominator:
Accounting rate of return = Incremental accounting income/Initial investment
If average investment is used as denominator:
Accounting rate of return = Incremental accounting income/Average investment
*Average investment in project:
($650,000 + $20,000)/2