Average rate of return on Investment

 FINANCIAL ANALYSIS: Finance Assignment Help

Implementing projects, involving large expenditure is a strategic decision - it is both long term and not easily reversible. Wrong decision can land the company into major problems. At the same, without taking up projects for expansion and upgradation, companies cannot maintain and improve their profitability. These projects involving large capital outlays have to be appraised from a `private' or financial point of view - this evaluation is from the view point of promoters who may be individuals, corporate, commercial and development institutions, 'development corporations, central or state governments or their agencies. This evaluation is required before these are sanctioned for implementations. Method of evaluation may be the traditional ones - unsophisticated like Average Rate of Return (or Return on Investment) and Playback Period or time-adjusted techniques like Net Present Value, Internal Rate of return etc.

AVERAGE RATE OF RETURN ON INVESTMENT (ROI) 

This is an accounting method. There is no agreement on the definition and a number of alternative methods of calculating it are available. The most ratio used commonly  is: 

Average Annual Profit after taxes x 100 Average Investment over the project life 

Average Annual Profit after taxes is calculated by adding up the after-tax profits for each year of project life and dividing it by the no. of years of estimated useful life (for annuities, after-tax profit is equal to one year's profit). 

Average Investment over the project file is computed by dividing the net investment by two (straight line depreciation is assumed) and adding the salvage value that would be received at the end of the projected life (since it remains invested throughout) and full amount of working capital required.

PAY BACK PERIOD (PB) 

Pay Back Period (PB) is a traditional method which is simple and most widely used for project evaluation. It is a measure, in terms of time, it will take to recover from proposed operations, the initial cash investment, which normally disregards the salvage value of the equipment at the end of its useful life. 

 Pay Back Period (PB) = Initial Investment /Constant Annual Cash Flow (CFAT) 

Usually, the cash flows every year are not equal as they vary from year to year, in which case, the calculations are: 

Pay Back Period (PB) = Original Cost of Acquisition /Cash Flow after Tax (CFAT)

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