Page 125 - DMGT409Basic Financial Management

Basic Financial Management

Notes Payback period = Initial Investment ÷ Constant Annual Cash Infl ows

PBP of Automatic Machine = 2,24,000 ÷ 54,400 = 4.11 Years
PBP of Ordinary Machine = 60,000 ÷ 13,750 = 4.36 Years
Advice: The payback period in case of automatic machine is shorter. Hence automatic machine
is preferable.

Working Note: Depreciation = (Original Investment – Scrap Value) ÷ Life Period
Automatic Machine: (2, 24,000 – 0)/5 = ` 44,800
Old Machine: (60,000 – 0)/8 = ` 7,500
Assumption: Tax rate assumed as 50 per cent
Illustration 4: A project costs `20 lakh and yields annually a profi t of `3, 00,000 after depreciation
at 12½ per cent but before tax at 50 per cent. Calculate payback period and suggest whether it
should be accepted or rejected based on 6 year standard pay back period.

Solution:
Calculation of Cash Flows After Tax

Particulars Amount (`)
Profit After Depreciation before Taxes 3,00,000

Less: Taxes at 50% 1,50,000
EAT 1,50,000
Add: Depreciation (Note) 2,50,000
Cash infl ow (CFAT) 4,00,000
Payback period = Initial Investment ÷ Constant Annual Cash Infl ows
Payback period = `20,00,000 ÷ `4,00,000 = 5 years
Decision: Project should be accepted since calculated PBP is less than the standard PBP
Working Note: Depreciation = Cost of Project × Depreciation Rate

= 20,00,000 × 0.125 = `2,50,000

Accounting Rate of Return/Average Rate of Return (ARR)
Accounting rate of return method uses accounting information as revealed by fi nancial
statements, to measure the profitability of the investment proposals. It is also known as the

return on investment (ROI). Some times it is known as average rate of return (ARR). Average
annual earnings after depreciation and taxes are used to calculate ARR. It is measured in terms
of percentage. ARR can be calculated in two ways.

1. Whenever it is clearly mentioned to calculate accounting rate of return.
If accounting rate of return is given in the problem, return on original investment method
should be used to calculate accounting rate of return.
AverageannualEATorPAT
Accounting Rate of Return (ARR) = × 100
()*
Originalinvestment OI
* OI = Original investment + Additional NWC + Installation Charges + Transportation
Charge

118 LOVELY PROFESSIONAL UNIVERSITY