Inflows and outflows from providing the service are expected to be as follows:
Time £000
Immediately Cost of machine (100)
1 year’s time Operating profit before depreciation 20 2 years’ time Operating profit before depreciation 40 3 years’ time Operating profit before depreciation 60 4 years’ time Operating profit before depreciation 60 5 years’ time Operating profit before depreciation 20 5 years’ time Disposal proceeds from the machine 20
Sales revenues result in cash flowing into the business and expenses tend to lead to it flowing out. Depreciation, however, does not involve an outlay of cash, it is simply a bookkeeping exercise. (The outlay of cash occurs when the asset is first acquired.) In broad terms, therefore, the operating profit before deducting depreciation (that is, before non-cash items) will be equal to the net cash amount flowing into the business. For the time being, we shall assume that working capital – which is made up of inventories, trade receivables and trade payables – remains constant.
To simplify matters, we shall assume that the cash from sales and for expenses relating to the service is received and paid, respectively, at the end of each year. This is clearly not the case in real life. Money must be paid to employees (for salaries and wages) on a weekly or a monthly basis. Customers will pay within a month or two of buying the ser- vice. Making the assumption, however, probably does not lead to any serious distortion.
It is a simplifying assumption, that is often made in practice, and it will make things more straightforward. We should be clear, however, that there is nothing about any of the four methods that demands that this assumption is made.
Having set up the example, let us now go on to consider how each of the appraisal methods works.
ACCOUNTING RATE OF RETURN (ARR)
The first method that we shall consider is the accounting rate of return (ARR). This method takes the average annual operating profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the investment project. In other words:
ARR = Average annual operating profit
Average investment to earn that profit 3 100%
We can see from the equation that, to calculate the ARR, we need two pieces of information concerning the particular project:
■ the annual average operating profit, and
■ the average investment.
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152 CHAPTER 4 MAKING CAPITAL INVESTMENT DECISIONS
In our example, the average annual operating profit before depreciation over the five years is £40,000 (that is, £(20 + 40 + 60 + 60 + 20)000/5) Assuming ‘straight-line’ deprecia- tion (that is, equal annual amounts), the annual depreciation charge will be £16,000 (that is,
£(100,000 - 20,000)/5). Thus, the average annual operating profit after depreciation is £24,000 (that is, £40,000 - £16,000).
The average investment over the five years can be calculated as follows:
Average investment = Cost of machine + Disposal value*
2
= £100,000 + £20,000 2
= £60,000
*Note: To find the average investment, we are simply adding together the value of the amount invested at the beginning and end of the investment period and dividing by two.
Thus, the ARR of the investment is:
ARR = £24,000
£60,000 * 100% = 40%
In order to make sense of the ARR calculated above, the following decision rules should be applied:
Chaotic Industries is considering an investment in a fleet of ten delivery vans to deliver its products to customers. The vans will cost £15,000 each to buy, which is payable immedi- ately. The annual running costs are expected to total £50,000 for each van (including the driver’s salary). The vans are expected to operate successfully for six years, at the end of which period they will all have to be sold. The disposal proceeds are expected to be about £3,000 per van. At present, the business outsources its deliveries, to a commercial carrier. The carrier is expected to charge a total of £530,000 each year for the next six years to undertake this service.
What is the ARR of buying the vans? (Note that cost savings are as relevant a benefit from an investment as net cash inflows.)
Activity 4.2
■ For a project to be acceptable, it must achieve a target ARR as a minimum.
■ If there are two, or more, competing projects that achieve the target ARR, the one with the higher (or highest) ARR should be selected.
Thus, for the 40 per cent return to be acceptable, it must at least achieve the target ARR set by the business.
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ACCOUNTING RATE OF RETURN (ARR) 153
The vans will save the business £30,000 a year (that is, £530,000 - (£50,000 * 10)), before depreciation, in total. Thus, the inflows and outflows will be:
Time £000
Immediately Cost of vans (10 * £15,000) (150)
1 year’s time Saving before depreciation 30
2 years’ time Saving before depreciation 30
3 years’ time Saving before depreciation 30
4 years’ time Saving before depreciation 30
5 years’ time Saving before depreciation 30
6 years’ time Saving before depreciation 30
6 years’ time Disposal proceeds from the vans (10 * £3,000) 30 The total annual depreciation expense (assuming a straight-line method) will be £20,000 (that is, (£150,000 - £30,000)/6). Thus, the average annual saving, after depreciation, is
£10,000 (that is, £30,000 - £20,000).
The average investment will be:
Average investment = £150,000 + £30,000
2 = £90,000
and the ARR of the investment is:
ARR = £10,000
£90,000 * 100% = 11.1%
ARR and ROCE
In essence, ARR and the return on capital employed (ROCE) ratio take the same approach to measuring business performance. Both relate operating profit to the investment required to gener- ate that profit. However, ROCE assesses the overall performance of the business after it has per- formed, while ARR assesses the performance of a particular investment before it has performed.
We saw that investments must achieve a minimum target ARR. Given the link between ARR and ROCE, this target could be based on some measure of ROCE. It could, for example, be based on the industry-average ROCE, or the past ROCE of the business.
The link between ARR and ROCE appears to strengthen the case for adopting ARR as the appropriate method of investment appraisal. ROCE is a widely used measure of profitability and some businesses express their financial objective in terms of a target ROCE. It may seem logical, therefore, to use a method of investment appraisal that is consistent with this overall measure of business performance. A secondary point in favour of ARR is that it provides a result expressed in percentage terms, which many managers seem to prefer. Such advantages, however, are far outweighed by the serious problems associated with this method.
Problems with ARR
ARR suffers from a major defect as a means of assessing investment opportunities. To illustrate this defect, consider Activity 4.3.
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154 CHAPTER 4 MAKING CAPITAL INVESTMENT DECISIONS
A business is evaluating three competing projects whose profits are shown below. All three involve investment in a machine that is expected to have no residual value at the end of the five years. Note that all the projects have the same total operating profits after depreciation over the five years.
Time Project A
£000
Project B
£000
Project C
£000
Immediately Cost of machine (160) (160) (160)
1 year’s time Operating profit after depreciation 20 10 160 2 years’ time Operating profit after depreciation 40 10 10 3 years’ time Operating profit after depreciation 60 10 10 4 years’ time Operating profit after depreciation 60 10 10 5 years’ time Operating profit after depreciation 20 160 10
What defect in the ARR method would prevent it from distinguishing between these competing projects? (Hint: The defect is not concerned with the ability of the decision maker to forecast future events, though this too can be a problem. Try to remember the essential feature of investment decisions, which we identified at the beginning of this chapter.)
In this example, each project has the same total operating profit over the five years (£200,000) and the same average investment of £80,000 (that is, £160,000/2). This means that each project will give rise to the same ARR of 50 per cent (that is, £40,000/£80,000).
ARR, therefore, fails to distinguish between them even though they are not of equal merit.
This is because ARR ignores the time factor and, therefore, the cost of financing the project.
Activity 4.3
Example 4.2
George put forward an investment proposal to his boss. The business uses ARR to assess investment proposals using a minimum ‘hurdle’ rate of 27 per cent. Details of the proposal were as follows:
Cost of equipment £200,000
Estimated residual value of equipment £40,000
Average annual operating profit before depreciation £48,000
Estimated life of project 10 years
Annual straight-line depreciation charge £16,000 (that is,
[(£200,000 - £40,000)/10]
To maximise the wealth of the owners, a manager faced with a choice between the three projects set out in Activity 4.3 should select Project C. This is because most of the benefits arise within 12 months of making the initial investment. Project A would rank second and Project B would finish a poor third. Any appraisal technique that is incapable of distinguishing between these three situations is seriously flawed. We will look at why timing is so important later in the chapter.
The ARR method suffers from further problems, which are discussed below.
Use of average investment
Using the average investment in calculating ARR can lead to daft results. Example 4.2 below illustrates the kind of problem that can arise.
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ACCOUNTING RATE OF RETURN (ARR) 155
The ARR of the project will be:
ARR = £48,000 - £16,000
(£200,000 + £40,000)/2 * 100% = 26.7%
The boss rejected George’s proposal because it failed to achieve an ARR of at least 27 per cent. Although George was disappointed, he realised that there was still hope. In fact, all the business had to do was to give away the piece of equipment at the end of its useful life rather than sell it. The residual value of the equipment then became zero and the annual depreciation charge became ((£200,000 - £0)/10) = £20,000 a year. The revised ARR calculation was then as follows:
ARR = £48,000 - £20,000
(£200,00 + 0)/2 * 100% = 28%
Use of accounting profit
We have seen that ARR is based on the use of accounting profit. When measuring performance over the whole life of a project, however, it is cash flows rather than accounting profits that are important. Cash is the ultimate measure of the economic wealth generated by an investment.
This is because it is cash that is used to acquire resources and for distribution to the owners.
Accounting profit is more appropriate for reporting achievement on a periodic basis. It is a useful measure of productive effort for a relatively short period, such as a year or half-year.
Thus, it is a question of ‘horses for courses’.
Target ARR
We saw earlier a target ARR against which to assess investment opportunities that must be chosen. This cannot be objectively determined and so will depend on the subjective judgement of managers. The target ARR may therefore vary over time. It is also likely to vary between businesses.
Competing investments
The ARR method can create problems when considering competing investments of different size. Consider Activity 4.4.
Sinclair Wholesalers plc is considering opening a new sales outlet in Coventry. Two pos- sible sites have been identified for the new outlet. Site A has an area of 30,000 sq m. It will require an average investment of £6 million and will produce an average operating profit of
£600,000 a year. Site B has an area of 20,000 sq m. It will require an average investment of £4 million and will produce an average operating profit of £500,000 a year.
What is the ARR of each investment opportunity? Which site would you select and why?
Activity 4.4
➔
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156 CHAPTER 4 MAKING CAPITAL INVESTMENT DECISIONS
Increasing road capacity by sleight of hand
During the 1970s, the Mexican government wanted to increase the capacity of a major four-lane road. It came up with the idea of repainting the lane markings so that there were six narrower lanes occupying the same space as four wider ones had previously done. This increased the capacity of the road by 50 per cent (that is, 2/4 * 100). A tragic outcome of the narrower lanes was an increase in deaths from road accidents. A year later the Mexican government had the six narrower lanes changed back to the original four wider ones. This reduced the capacity of the road by 33 per cent (that is, 2/6 * 100). The Mexican govern- ment reported that, overall, it had increased the capacity of the road by 17 per cent (that is, 50% – 33%), despite the fact that its real capacity was identical to that which it had been originally. The confusion arose because each of the two percentages (50 per cent and 33 per cent) is based on different bases (four and six).
Source: Gigerenzer, G. (2002) Reckoning with Risk, Penguin.
Real World 4.3
The ARR of Site A is £600,000/£6m = 10 per cent. The ARR of Site B is £500,000/£4m = 12.5 per cent. Thus, Site B has the higher ARR. In terms of the absolute operating profit generated, however, Site A is the more attractive. If the ultimate objective is to increase the wealth of the shareholders of Sinclair Wholesalers plc, it would be better to choose Site A even though the percentage return is lower. It is the absolute size of the return rather than the relative (percentage) size that is important. This is a general problem of using comparative measures, such as percentages, when the objective is measured in absolute terms, such as an amount of money.
Real World 4.3 illustrates how using percentage measures can lead to confusion.