5.49 ACCOUNTING RATE OF RETURN Problem 21 :CatCulate the average rate of return for Projects A and from the following. Project Project A oa Investments Rs. 20,000 Rs. 30,009 Expected Life Ayears 5S years (no salvage value) Projected Net Income (after interest, depreciation and taxes) Years Project A Project B | Rs, Rs. | jh 2,000 3,000 | 2 1,500 3,000 | 3 1,500 2,000 4 1,000 1,000 \ B iin 1,000 | Foley 6,000 “10,0007 7 | If the required nd of return is 12%, which project should be | undertaken? Solution : es sa \ Project A Project B \ Total profit (after depreciation interest and taxes) —_ Rs, 6,000 Rs, 10,000. Life of the project 4years_- 5 years — i 6,000 10,000 | Averagenet profit ~q =Rs.1,500 ~E eRe, 2,000 E ‘\ Investmentin the project Rs. 20,000 Rs. 30,0007 | Accountini , rate of return: 1. Ayerate Net Pr 1,500~ 2,000 J x 109 1,500" z \~ | Ofiginal Investment 20,000 * 100 > x I 30,000 * 10° 75 6.67% (OR)5.50 Average Net Peofit. 199, 1,500. 199 2,000 100 Average Investment 10,000 15,000 : 15% 13.33% Investment at the beginning + Investment at the end 2 30,000 +0 Average Investment same Poe Rs. 10,000 Rs. 15,000 Problem 22: A company has two alternative proposals. The details are: Proposal I Proposal II Automatic Ordinary machine machine Cost of the machine Rs. 2,20,000 Rs. 60,000 Estimated life 5i4 years 8 years Estimated sales p.a. Rs. 1,50,000 Rs. 1, 50,000 Costs: Material 50,000 50,000 Labour 12,000 60,000 Variable Overheads 24,000 20,000 Compute the profitability of the proposals under the Return on Investment method. (B.Com., Bharathidasan) Solution : Profitability Statement Automatic Ordinary Machine Machine Cost of the machine - 2,20, Rs. 60,000 Life of the machine 5iA years 8 years Estimated Sales (A) 1,50,000 150,000 Less: Cost: Material 50,000. 50,000 Labour 12,000 60,000 Variale overheads 24,000 20,000 Depreciation (1) 7,500 Total Cost (B) 1,26,000 1,37,500 Profit (A) - (B) 24,000 12, FM-125.51 Working: Depreciation = Cost + Life ‘Automatic machine = 2,20,000 + 5% = 40,000 Ordinary machine = 60,000 + 8 = 7,500 Average Profit Return on Investment= Original Investment * 100 Automatic Ordinary Negiee Machine 24,000 12,500 220,000 * 1” 60,009 * 100 = 109% 20.8 % Automatic machine is more profitable than the ordinary Machine. Problem 23 : The following particulars relate to two machines producing identical products. Machine MachineB Original cost Rs. 1,00,000 1,50,000 Working life 5 years 5 years Profit before depreciation Rs, Rs, TYear 30,000 40,000 Year 15,000 45,000 Year 40,000 50,000 IV Year 40,000. 24,000 VYear 35,000 71,000 Tax rate 50% 50% a) Calculate Retum on Investments b) Calculate Average rate of thidasan) Solution ; OAC AnBhars i Cost - Se h Depreciation Ppa, =—~ rap value 00 Life of themachine ~6.52 Depreciation: Machine A Machine B 10000010000 1,00 ‘seen 200% =Rs.26,000 Calculation of Profit - Machine A Year Profitbefore Depn. Profitafter Tax@ Profit after Depn. & tax Depn. 50% Tax Rs. Rs. Rs. Rs. Rs. 30,000 18,000 12,000 += 6,000-—S—«6,000 15,000 18,000 - 3,000 - — -3,000 40,000 18,000 22,000 11,000 11,000 40,000 18,000 22,000 11,000 11,000 35,000 18,000 17,000 = 8500. _ 8,500 Total Profit 33,500 Average annual profit = 33,500 = 5 = Rs. 6,700 Calculation of Profit - Machine B Year Profitbefore Depn. Profitafter Tax@ Profitafter Depn. & tax Depn. 50% Tax Rs. Rs. Rs. Rs. Rs. Seg Oe eS 1. 40,000 26,000 14,000 © 7,000 -~=—7,000, 2 45,000 26,000 19,000 © 9,500 9,500. 3. 50,000 26,000 24,000 ©» -12,000-——«12,000 4. 24,000 26,000 -2,000 = -2,000 5 71,000 26,000 45,000 22,500 22,500. Total Profit 49,000 Average annual profit = 49,000> 5 =Rs. 9,800 AverageAnnualProfit gy Return on Investment= “Gy iginal Investment Machine A Machine B 6,100 9,800 Retumoninvestment= 799,999 “°° 730,000 *! 6.7% 6.53%5.53 Average Annual Profit Return on Average Investment = AverageInvestment * 100 Average Investment Investmentat thebeginning+ Investmentat theend (Scrap) Value) 2 Machine A Machine B 1,50,000 + 20,000 at ae 1,00,000 + 10,000 Average Investment = eee 100 Rs. 55,000 Rs. 85,000 6,700 49 9,800 ro Return Average Investment = 35000 * 35,000 * for the last 5 years. 'gnoring interest but considering tax at 50% of net earnings, = B8est which ofthe two altematives hould be prefered, The following are the details. Old Machine New Machine Purchase price Rs. 40,000 Rs. 60,000 Estimated life of machine 10 years 10 years Machine running hours per annum 2,000 2,000 Units per hour 24 36 Wages per running hour 3 5.25 Power per annum 2,000 4,500 Consumable stores Per annum 6,000 7,500 All other charges per annum 8,000 9,000 Material cost per unit 0.50 050 Selling price per unit 1.25 125i5.54 You may assume that the above information regarding sales and cost of sales will hold good throughout the economic life of each of the machines. Depreciation has to be charged according to straight-line method. Calculate Accounting Rate of Return. (M.C.A., Bharathidasan) Solution : Profitability Statement Old Machine New Machine Cost of the Machine (Rs.) 40,000 60,000 Life of machine (yrs.) 10 10 Output (units) 48,000 72,000 Sales Value (Rs) 60,000 90,000 Less: Cost of sales: Direct material 24,000 36,000 Wages 6,000 10,500 Power 2,000 4,500 Consumable stores 6,000 7,500 Other charges 8,000 9,000 pasa ae 50,000 73,500 Profit before tax 10,000 16,500 Tax at 50% 5,000 8,250 Profit after tax 5,000 8,250 Note : Output = Units per hour x Running hours Accounting Rate of Return: Old Machine New Machine Average Net Profit (Orieinal nea cae 5,000. 100 = 125% 8250 199 = 13.75% 40, 60,0005.55 siveras CNEL OoO Te Average Investment 8,250 30,000 x 100 = 27.50%, 5000. 109 = 25% 000 Thus, replacement of the old machine by a new machine plan, Estimated cashflows are: Problem 25: Excellent Ltd is considering three alternative items of A plant. Estimated cashflows are: a So oo. Sa 0 20,000 20,000 40,000 1 6,000 12,000 - “J 6,000 14,000 15,000 3 6,000 14,000 15,000 4t010 6,000(p.a) — 12,000 (p.a.) Inrespect of each project calculate the following and rank them. a) Pay back period b) Retum on investment Solution : Pay-back period: Project A Cash flows are uniform Initial investment Annual cash inflow Pay-back period = Rs.20,000 = 6,000 = 3 years 4 months Project Band C: Cash 4, Ows ae not uniform. Hence cumulative cashflows are tobe considered for finding out the pay-back period.5.56 Cumulative Cash inflows of Projects B and C Project B Project C Year Cash Cumulative Cash Cumulative inflows Cash inflows inflows —_Cash inflows Rs, Rs. Rs. Rs. 1 12,000 12,000 = a 2 14,000 26,000 15,000 15,000 3 14,000 40,000 15,000 30,000 4 ba 40,000 12,000 42,000 Project B: Investment is Rs. 20,000. Rs. 12,000 is recovered in the first year. The remaining Rs. 8,000 is to be recovered in the second year. In the second year, For recovery of Rs. 14,000 time required = 12 months For recovery of Rs. 8,000 time required 8,000 74,000 * 22. = 685months or 6 months 26 days Pay-back period = 1 year 6 months 26 days. Project C: Investmentis Rs. 40,000. Rs. 30,000 is recovered in 3 years. ‘The remaining Rs. 10,000 is to be recovered in the fourth year. Inthe second year, For recovery of Rs. 12,000 time required = 12 months For recovery of Rs. 10,000 time required 10,000 72,000 * 12 = 10 months Pay-back period = 3 years and 10 months. (&) Retumon Investment Average Annual Profit Retumon Investment = “Original Investment5.57 ; pareaivian tediied . Project A: Cash inflows are et in the problem, To ceri, profit, depreciation is to be deducted. Cost of the asset Depreciation = Life of the asset A B c aD 20.000 _ 6,667 40,000 _ merge = 2/000 3 ys “To = 40% Project A: (Life 10 years) Rs, Total cash inflows for 10 years. = 6,000x10 = 60,000 tess: Total Depreciation for 10 years = 2,000x 10 = 20,000 items Total profit for 10 years = _ 40,000 Average annual Profit = 40,000+ 10 = 4000 Rs. 4,000 Return on Investment “20,000 * 100 = 20% Project B: (Life 3 years) Rs, Total cash inflows for 3 years 12,000 + 14,000 + 14,000 = 40,000 Less: Total Depreciation for 3 years = 20,000 Total profitfor3 years = 20000, Average annual Profit = 20,000 + 3 = 6,667 Rs. 6,667 Return on Investment = 20,0007 X 100 = 33.35%,6.59 Solution : a) Pay-back method: : Statement of Cash inflow (Rs. in 000’) Year Profit Taxat Profit Depn Cash Cum.Cash 50% after tax inflows inflows r 200. 50 50 40 90 90 2 100 50 50 40 90 180 3 80 40 40 40 80 260 4 80 40 40 40 80 340 Bo 20 20 40 60 400 Pay back period : Rs. 1,80,000 is recovered in 2 years. The balance 20,000 of Rs. 20,000 will be recovered in ‘30,000 * 1=0.25 year. Hence pay- back period is 2.25 years or 2 years and 3 months. b)_ Rate of Return on Original investment Method: Year Net Profit after tax and depreciation Rs. SS i ool 2 50,000 3 40,000 4 40,000 5) 20,000 Total profits “2,00,000 = A 'verage Annual Profits = 2,00,000 + 5 = 40,000 Rate ofRetum = x 100 =20% C) Rate of Return on Average Investment Method:5.60 d) Discounted Cash Flow Method: Year Cash Discount Present Value inflows factor @ 10% Rs. 1 Rs. 90,000 0.909 81,810 2 90,000 0.826 74,340 3 80,000 0.751 60,080 4 80,000 0.683 54,640 5 60,000 0.621 37,260 Present value of cash inflows / 3,08,130 Less: Initial investment 2,00,000 Net Present Value 1,08,130 e) Excess Present Value Index: Total present value of cash inf lows Total present value of cash outflows 3,08,130 2.00.000 x 100 x 100 = 154%