Capital budgeting; ARR numerical, Rs 100000

Capital budgeting decision and its importance

Capital budgeting is the process of planning, evaluating and selecting long-term investment projects whose benefits come over several years (such as a new plant, road or building), by comparing the cash outlay with the expected future returns. The capital budgeting decision is the choice to accept, reject or rank such investments.

Importance:

1. Large funds are committed for a long period.
2. Decisions are irreversible; a wrong decision may cause heavy loss.
3. It decides the future growth and profit of the firm.
4. It affects the firm's risk and its cost of capital.
5. Funds are limited, so projects have to be ranked.
6. It needs a long-term forecast of demand, cost and technology.

ARR calculation

Assumptions: the income given is the annual income before depreciation and tax; the printed list has only four values for five years, so the year-5 income is taken as Rs 20,000 (the same as year 4); depreciation is by the straight-line method.

$$\text{Annual depreciation} = \frac{100{,}000 - 20{,}000}{5} = 16{,}000$$

(The negative tax in year 1 is the tax saving from the loss, set off against the other years' profit.)

$$\begin{aligned} \text{Average annual profit} &= \frac{15{,}000}{5} = 3{,}000\\ \text{Average investment} &= \frac{100{,}000 + 20{,}000}{2} = 60{,}000\\ ARR &= \frac{3{,}000}{60{,}000} \times 100 = 5.00\% \end{aligned}$$

Answer: ARR = 5.00% (on average investment). The project is accepted only if this is more than the firm's required rate of return.