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Excel Finance Class 72: Investment Criteria: Average Accounting Return - YouTube
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welcome to finance and Excel video
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number 72 hey if you want to download
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this workbook chapter 8 click on the
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link directly below the video and scroll
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way down to the finance excel class
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section hey we're talking about
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investment criteria whether or not we
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should invest in the asset we've looked
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at net present value and payback now
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we're gonna look at the average
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accounting return there are many
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different definitions here's one you got
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to calculate the average net income so
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calculate the net income for each period
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and the calculating average and then
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divided by the average book value this
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sort of looks like return on assets
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right in Chapter three we did net income
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divided by the asset value and for that
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reason there are all no not for that
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reason there are other ways to calculate
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average accounting return besides just
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this some people just take the return on
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assets for each year and then average
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them now the steps for us are gonna be
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estimate all revenues and expenses over
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the life of the asset calculate the net
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income for each year estimate the book
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value now Book value is whatever the
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historical cost is subtract out all your
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accumulated depreciation so estimate the
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book value over the life of the asset
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and then we're going to calculate an
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average book value right because
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remember that's the gonna be the
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denominator we also going to have to
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decide in advance the target cut off pay
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our rate so this is the rate we anything
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above this we're going to accept
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anything below it we're not going to
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accept so this is the rate we want this
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is the average accounting rate we
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actually want decision rule accept the
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project if calculated AR is greater than
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the cutoff so this cut off is like the
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hurdle anything above it we're going to
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accept it now this is using accounting
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information right not as good as cash
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flow information financial managers use
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they like to deal with cash flows but so
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that's a big
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downside to this measure however people
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do use this because accounting
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information is usually easy to get all
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right let's see how to do this we've
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estimated this is the same exact example
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we've done let's see this is the same
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exact exact sample we did for net
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present value and payback except for we
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when we looked at this slide before we
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knew that these were the calculated
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amounts and this was the average book
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value so now we're gonna actually see
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how to calculate so we've estimated
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there's the revenue there's the expenses
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and these are all the expenses including
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depreciation tax so we will calculate
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our net income for each year all their
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revenues - oh all of the expenses
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control-enter and I'm gonna drag that
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over all right now average we're going
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to use the average function adds them
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all up divides by the count so adds them
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all up divides by three so that's the
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average net income over the life of this
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project here now Book value book value
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well first we need to calculate our
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depreciation depreciation the idea
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behind depreciation I know this is not
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an accounting class but it's simple 180
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thousand dollars for the original cost
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if you took that as an expense in the
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first year the expense would be too big
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because this assets gonna last over
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three years so the idea is you got to
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chop it into three pieces and put some
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in each year all right so the one way to
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do depreciation is straight line and
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we're going to assume that at the end of
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three years it'll have no value so the
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salvage value is zero so here's our
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depreciation calculation original cost
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minus the salvage divided by the number
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of the years and that's how much we're
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gonna take each year now Book value well
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at times zero what's the book value this
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now after one year the accumulated
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depreciation there is a depreciation
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expense which hits the income statement
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and there's also a balance sheet account
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called accumulated depreciation and
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so at the end of one year we take the
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hundred the original historical cost and
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subtract the accumulated depreciation
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now here it's minus sixty thousand and
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you may imagine if you were looking at
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the accumulated depreciation account at
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the end of year two it would say a
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hundred and twenty because there's been
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two years where we took sixty thousand
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but for this calculation we're trying to
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figure out the Book value so this this
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I'm just gonna say whatever the book
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value from last period minus that and
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I'm gonna hit the f4 key to lock it so
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right now we could see one hundred
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twenty minus sixty that means the
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balance will be this when I copy this
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over of course we're going to get zero
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now you take the average and the reason
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I'm showing you this calculation there's
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an easier way to do average book value
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when you have straight line and it goes
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down to zero here but I'm showing you
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how to do it each year because if you
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don't have depreciation straight line
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depreciation method then you got to
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calculate your book value whatever
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whatever calculation have the book value
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for each individual year whatever those
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calculations are and then you average
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them so 90,000 now the easy way to do
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this and is to simply given that we have
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straight line down to zero we simply say
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that / - right and all the examples in
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this textbook that's what they'll give
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you right but the that method that long
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method gets you the same thing and if
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for some reason there's a different
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depreciation method than straight line
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that will work now we have our numbers
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we have average net income average book
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value we can simply divide the two right
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this kind of like return on assets
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here's the average return over in
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accounting numbers over the project
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here's the average book value over the
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period and boom so we get an aar of
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0.214 eight our target hurdle is 25 so
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no way we reject Roger
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all right now of course the problems are
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many with the accounting average
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accounting rate rule does not adjust for
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the time value money rule does not
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adjust for risk meaning as we saw with
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net present value the discount rate or
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required rate of return would include
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the risk and rule does not provide
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information on whether we create value
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or not the only advantages you know some
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people say well you know the accounting
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information is easy to get whereas the
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cash flow information may be a little
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bit the accounting the cash flow
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information is hard - harder to get than
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say the accounting but you know this is
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all riddled with estimations where again
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we're doing estimating into the future
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so it does seem like might as well do
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the net present value method
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nevertheless some people do do this and
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to reiterate what I said earlier people
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use multiple decision criteria so they
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might do net present value this
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accounting rate of return and payback or
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something like that
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all right when we come let's see when we
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come back in next video we'll actually
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talk about the IRR the internal rate of
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return closely related to net present
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value all right see you next video
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