Page 176 - DMGT521_PROJECT_MANAGEMENT

Unit 10: Measuring Project Profitability

10.2.1 Decision Rule Notes

Accept the project only if its ARR is not less than the required accounting rate of return. In case
of mutually exclusive projects, accept the one with highest ARR.

Example 1: An initial investment of $130,000 is expected to generate annual cash inflow
of $32,000 for 6 years. Depreciation is to be allowed on the straight line basis. It is estimated that
the project will generate a scrap amount of $10,500 at end of the 6th year. Calculate its accounting
rate of return assuming that there are no other expenses on the project.
Solution:
Annual Depreciation = (Initial Investment – Scrap Value)/Useful Life in Years
Annual Depreciation = ( $130,000 – $10,500 ) / 6 H” $19,917

Average Accounting Income = $32,000 – $19,917 = $12,083
Accounting Rate of Return = $12,083/$130,000 H” 9.3%

Example 2: Compare the following two exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:

Year 0 1 2 3
Cash Outflow –220
Cash Inflow 91 130 105
Salvage Value 10

Project B:

Year 0 1 2 3
Cash Outflow –220
Cash Inflow 91 130 105
Salvage Value 10

Solution:

Project A:
Step 1: Annual Depreciation = (220 – 10) / 3 = 70
Step 2:

Year 1 2 3
Cash Inflow 91 130 105
Salvage Value 10
Depreciation* –70 –70 –70
Accounting Income 16 60 45

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