 Hello and welcome to the session in which we will discuss simple rate of return or the accounting rate of return which is known as ARR. ARR or the simple rate of return is a tool that's going to help us judge the capital project. It's going to be part of the capital budgeting process. Now accounting rate of return or simple rate of return, those two words are interchangeable. It's taken us back to accounting figures in contrast to previous tools such as NPV such as IRR such as payback method. All these methods uses the cash flows. Well guess what? We're no longer using the cash flows here. We are using the accounting figures specifically net income or net operating income and to be more specific we're going to be using incremental net income. So simply put to compute the simple rate of return and notice it's simple. It's called simple. It means it's easy. In the enumerator we're going to use the annual incremental, incremental means the additional net operating income. Sometime that figure is given separately. Sometime you are giving incremental revenue and incremental expenses for the project. The difference between those two is annual incremental net operating income. Then you'll divide this by the initial investment. The initial investment can be reduced by any salvage value. If you sold an old asset to buy the new asset, well you can reduce the initial investment. Let's take a look at an example to illustrate this concept. Adam wants to install a new software. The cost of the software is $100,000, it has a 10 year life. The software generates incremental revenues of $100,000 and incremental expenses of $80,000 including depreciation. That's great. We don't care whether it's include depreciation or not. As long as it's an expense we are going to utilize it. Now we need to compute the simple rate of return for this project. How much would this project earn as a simple rate or accounting rate of return? The incremental revenue is $100,000. The incremental expense is $80,000 including depreciation therefore incremental income is $20,000. $20,000 divided by the cost of the project, the software $100,000 will give us an incremental return and not sorry, an accounting rate of return of 20%. Now is this acceptable or not? We have to compare this to our required rate of return. What is our required rate of return? How much do we want to earn on this project? If it's less than 20 and we are judging by ARR, it's acceptable. If not, it's not acceptable. Now this example is pretty much straightforward. Sometimes the example might be giving with little bit more of complications, little bit more of details you need to be aware of. So let's take a look at an example that will require little bit more of computation. But before we do so, let me remind you whether you are a student or a CPA candidate and this is most likely who you are if you are watching, go to farhatlectures.com. I don't replace your CPA review course. I don't replace your accounting courses. I'm a useful addition. I can help you do better. If you have not connected with me on LinkedIn, please do so. Like this recording. Subscribe. Connect with me on Instagram, Facebook, Twitter, and Reddit. So let's take a look at this example. Adam Company is contemplating the purchase of a new machine that would cost 100,000. So that's my cost 100,000. The machine is expected to generate an additional. Additional means incremental 20,000 per year after tax cash. This is the cash amount. The estimated useful life is 20 years with no residual value. Adam uses the straight line method for depreciating similar asset. The predetermined desired rate of return for Adam is 12%. The present value of an annuity of a dollar at 12%. For 10 periods is 5.65. The present value of a dollar due in 10 periods at 12% is 0.322. What is the accounting rate of return? Hold on a second. I read all of this and most of it was useless. First, I'm computing the accounting rate of return. Sometimes they call it the accrual or the simple. Accounting means accrual, but this is because we use accrual accounting. So simply put everything here I can ignore about time value. I don't need the time value whatsoever. All what I need is the incremental net income. Well, I know it will generate an additional $20,000. That's fine. However, this is cash. So it will generate an additional $20,000 cash. This is what I'm giving, but I don't need the cash. I need net income. Well, what does that mean? It means I need to deduct from that any expense. Well, what is the expense that I have? If I purchase the asset for 100,000, I'm going to be depreciating this asset over 20 years with no salvage value. It's going to give me a depreciation expense of five. Therefore, what I need to do from a cash perspective, I'm making 20,000 from an accrual perspective on only making 15,000. So what I did is I deducted the depreciation expense from the cash income. Again, you could have more complications, for example, taken into account the tax or not, so on and so forth, but the point is the incremental net income is 15,000. Now 15,000 divided by 100,000 will give me 15%. Is this an acceptable project? And the answer is yes, this is an acceptable project. And the reason is my predetermined minimum, minimum desired rate of return is 12. Now let me tell you, if this company depreciated their equipment for 10 years, my expense, my depreciation expense will be 10. Therefore, my cash net income will be 10. Therefore, my ARR will be 10, and therefore I would reject the project. And I'm pretty sure you already noticed this is one of the weaknesses in the ARR or the accounting rate of return is depending on the depreciation method that you are using, you may accept or reject a project which is not based on the viability of the project, well, it based on which accounting method you used. So what are some advantages and disadvantages? The advantages it's easy to use, accountant are comfortable with this because you are using net income, you are using depreciation figures, financial statement figures, takes into account the entire life of the project. Some disadvantages, it doesn't use the time value of money, it uses the nominal numbers. And if inflation is here, nominal numbers are useless. Accrual, not cash. Again, we're using accrual income, not cash income or cash flows, which is, as I just showed you, accrual income can be easily manipulated into accepting or rejecting a project. And the same project may appear desirable in some years, undesirable in other, if you change accounting methods, so on and so forth. What should you do now? Go to Farhat Lectures and work MCQs to learn about capital budgeting and the tools you need to judge those capital budgeting projects. Good luck, study hard and of course, stay safe.