184 ACCOUNTING FOR MANAGERS
Table 12.1 Cash flows for investment alternatives
Year Project 1 Project 2 Project 3
0 initial investment −100,000 −125,000 −200,000
1 inflows 25,000 35,000 60,000
2 inflows 25,000 35,000 60,000
3 inflows 25,000 35,000 80,000
4 inflows 25,000 35,000 30,000
5 inflows 25,000 35,000 30,000As we consider each method, let us assume three alternative investments.
Table 12.1 shows the estimated cash flows.
For simplicity, we assume that each of the cash flows occurs at the end of each
year. Year 0 represents the beginning of the project when the initial funds are
paid out. If we add up the cash flows in the above example, Project 1 returns
£125,000 (5 @ £25,000), Project 2 returns £175,000 (5 @ £35,000) and Project 3 returns
£260,000 (2 @ £60, 000 +£80, 000 +2 @ £30,000), although the initial investment in
each is different.
Accounting rate of return.................................
The accounting rate of return (ARR) is the profit generated as a percentage of
the investment. This is equivalent to the return on investment (ROI) that was
introduced in Chapter 7. The investment value for ARR is the depreciated value
each year. The depreciated value each year, assuming a life of five years with no
residual value at the end of that time, is shown in Table 12.2. The accounting rate
of return varies annually, as Table 12.3 shows for Project 1.
For the whole investment period, the accounting rate of return is the average
annual return divided by the average investment. The average annual return is
the total profit divided by the number of years. As we assume that depreciation is
spread equally throughout the life of the asset, the average investment is half the
initial investment, i.e. half-way through its life.
total profits/no. of years
initial investment/2Table 12.2 Depreciated value of alternative investments
End of year Project 1 Project 2 Project 3
1 80,000 100,000 160,000
2 60,000 75,000 120,000
3 40,000 50,000 80,000
4 20,000 25,000 40,000
5000