Capital budgeting decision

The ARR, also known as the return on investment (ROI), uses accounting information, as revealed by financial statements, to measure the viability of an investment. The ARR is the ratio of the average after tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly. Alternatively, it can be found by dividing the total investment’s book values after depreciation by the life of the project. The ARR thus, is an average rate and can be determined by the following equation:

ARR = Average income

Average Investment

Average income should be defined in terms of earnings after taxes without an adjustment for the interest EBIT (1 - T) or net operating profit after tax. Thus

Where:

EBIT = earnings before interest and taxes

T= Tax rate

𝐈𝐨= book value of the investment at the beginning

𝐈𝐧=book value of the investment at the end of n number of years

EXAMPLE

A project will cost Tshs40m/=. Its streams of earnings before depreciation, interest and taxes (EBDIT)during first year through five years is expected to be Tshs10m/=, Tshs12m/=, Tshs14m/=, Tshs16m/= and Tshs20m/=. Assume a 30% tax rate and depreciation on straight line basis.

ACCEPTANCE RULE

As an accept or reject criterion, this method will accept all those projects whose ARR is higher than the minimum rate established by the management and rejects those projects which have ARR less than the minimum rate. This method would rank projects as number one if it has highest ARR and lowest rank would be assigned to the project with the lowest ARR.

DISCOUNTED CASH FLOW METHOD

1. Net present value method (NPV)

The NPV of an investment is the difference between the present value of the initial outlay and the present value of the streams of the expected cash-inflows. It is the sum of the present value of the cash inflows minus the initial investment. It involves the process of calculating the present value of cash flows of an investment using the cost of capital as the discount rate.