X company is considering the purchase of a machine from among machines A and B. From the following information relating to the machines ascertain which machine will be profitable under the ARR method. The Average rate of tax is 50%.
Machine A Machine B
Cost of machine 100000 160000
Expected life 4 years 6 years
Earnings after depreciation and before tax
1 20000 16000
2 30000 28000
3 40000 50000
4 30000 60000
5 nil 36000
6 nil 26000
ARR = Avg earnings x100
Avg investment
Machine A Machine B
Total earnings before tax 120000 216000
Avg earning before tax 30000 36000
Avg annual earning after 50% tax 15000 18000
Cost of machine 100000 160000
Avge investment 50000 80000
ARR 15000/50000 18000/80000
= 30% = 22.5%
ARR for machine A is higher. So we select machine A
Advantages
- Easy to calculate and simple to understand
- Emphasis is placed on the profitability of the project and not on liquidity.
- The earnings over the entire life of the project is considered for ascertaining ARR.
Disadvantages
- This method ignores the time value of money
II a. Net present Value method (NPV method)
The NPV method gives consideration of the time value of money.
Steps
- Determine an apt rate of interest to discount cash flow.
- Compute the present value of cash out flow at the determined discounting rate.
- Compute the present value of total cash inflows (profit before depreciation and after tax), at the above determined discount rate.
- Subtract the present value of cash outflow from the present value of cash inflow to arrive at the net present value.
- If the NPV is –ve , the project proposal will be rejected. If the NPV is 0 or +ve the proposal can be accepted.
- If the projects are ranked, the project with the maximum NPV should be chosen
