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Chapter 26: Q13RQ (page 1464)

How is ARR calculated?

Short Answer

Expert verified

Answer

ARR=AverageannualoperatingincomeAverageamountinvested

Step by step solution

01

Meaning of ARR

ARR depicts the effect of the investment on the company's accrual-based income.

02

Calculation of ARR

ARR is calculated using accrual accounting rather than net cash inflows. It is required for users of financial statements.Calculation of ARR helps the companies to analyze the profitability of the investment.

The formula that is involved in finding ARR is as follows:

ARR=AverageannualoperatingincomeAverageamountinvested

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Most popular questions from this chapter

Question: Defining capital investment terms

Fill in each statement with the appropriate capital investment analysis method:

Payback, ARR, NPV, or IRR. Some statements may have more than one answer.

  1. _____ is (are) more appropriate for long-term investments.
  2. _____ highlights risky investments.
  3. _____ shows the effect of the investment on the company’s accrual-based income.
  4. _____ is the interest rate that makes the NPV of an investment equal to zero.
  5. _____ requires management to identify the discount rate when used.
  6. _____ provides management with information on how fast the cash invested will be recouped.
  7. _____ is the rate of return, using discounted cash flows, a company can expect to earn by investing in the asset.
  8. _____ does not consider the asset’s profitability.
  9. _____ uses accrual accounting rather than net cash inflows in its computation.

Question: What is an annuity? How does it differ from a lump sum payment?

How is payback calculated with unequal net cash inflows?

Question: Using the payback and accounting rate of return methods to make capital investment decisions

Consider how Hunter Valley Snow Park Lodge could use capital budgeting to decide whether the \(11,000,000 Snow Park Lodge expansion would be a good investment. Assume Hunter Valley’s managers developed the following estimates concerning the expansion:

Number of additional skiers per day 121 skiers

Average number of days per year that weather conditions

allow skiing at Hunter Valley 142 days

Useful life of expansion (in years) 7 years

Average cash spent by each skier per day \) 241

Average variable cost of serving each skier per day 83

Cost of expansion 11,000,000

Discount rate 10%

Assume that Hunter Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $600,000 at the end of its seven-year life.

Requirements

  1. Compute the average annual net cash inflow from the expansion.
  2. Compute the average annual operating income from the expansion.

What is the decision rule for payback?
See all solutions

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