Capital Budgeting: Long Range Planning

Another method of evaluating investment projects that you are likely to encounter in practice is the unadjusted rate of return method. To compute the unadjusted rate of return, divide the average annual income after taxes by the average amount of investment in the project. The average investment is the (Beginning balance + Ending balance)/2. If the ending balance is zero (as we assume), the average investment equals the original cash investment divided by 2. The formula for the unadjusted rate of return is:

$\text{Unadjusted rate of return} = \dfrac{\text{Average annual income after taxes}}{\text{Average amount or investment}}$

Notice that this calculation uses annual income rather than net cash inflow.

To illustrate the use of the unadjusted rate of return, assume Thomas Company is considering two capital project proposals, each having a useful life of three years. The company does not have enough funds to undertake both projects. Information relating to the projects follows:

Assuming a 40 percent tax rate, Thomas Company can determine the unadjusted rate of return for each project as follows:

From these calculations, if Thomas Company makes an investment decision solely on the basis of the unadjusted rate of return, it would select Proposal l since it has a higher rate.

Also, the company could compute the unadjusted rate of return with the following formula:

$\text{Rate of return} = \dfrac{(\text{Average annual before - tax net cash inflow - Average annual depreciation) x ( 1 - Tax rate)}}{\text{Average investment}}$

For Proposal 1, the computation is as follows:

$\text{Rate of return} =$ $\dfrac{\text{USD 45,000 - USD 24,000)X( 1-0.4)}} {\text{(USD 76,000 + USD 4,000 ) /2}}$

$= \dfrac{\text{USD 21,000 x 0.6}}{\text{USD 40,000}} = \dfrac{\text{USD 12,600}} {\text{USD 50.000}} = \text{30 percent}$ 

For Proposal 2, the computation is as follows:

$\text{Rate of return} = \dfrac{\text{(USD 55,000- USD 30,000 )X( 1 -0,4)}} {\text{(USD95.000+ USD5,000)/2}}$

$= \dfrac{\text{USD 25,000 x 0.6}} {\text{USD 50,000}} = \dfrac{\text{USD 15,000}}{\text{USD 50,000}} = \text{30 percent}$

Sometimes companies receive information on the average annual after-tax net cash inflow. Average annual after-tax net cash inflow is equal to annual before-tax cash inflow minus taxes. Given this information, the firms could deduct the depreciation to arrive at average net income. For instance, for Proposal 2, Thomas Company would compute average net income as follows:

The unadjusted rate of return, like payback period analysis, has several limitations:

• The length of time over which the return is earned is not considered.
• The rate allows a sunk cost, depreciation, to enter into the calculation. Since depreciation can be calculated in so many different ways, the rate of return can be manipulated by simply changing the method of depreciation used for the project.
• The timing of cash flows is not considered. Thus, the time value of money is ignored.

Unlike the two project selection methods just illustrated, the remaining two methods - net present value and time-adjusted rate of return - take into account the time value of money in the analysis. In both of these methods, we assume that all net cash inflows occur at the end of the year. Often used in capital budgeting analysis, this assumption makes the calculation of present values less complicated than if we assume the cash flows occurred at some other time.