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fahad says

Sir , today i was doing ARR questions in a class , and i have deducted the scrap value from the cost of machine but my lecturer told me its a wrong method , but i was doing this every time when i have scrap value in a question , i m confused , i don’t know what to do , help me sir please ..

John Moffat says

For ARR you need the average investment in the Statement of financial position (balance sheet). This is (initial investment + scrap value) /2.

Think about this. Suppose you bought a machine with a cost of 100,000 and a scrap value of zero. The value in the SOFP would fall each year (because of depreciation) and the average value would be 50,000.

Now suppose you bought the same machine with the same cost, but with a scrap value of 20,000. The value in the SOFP would again fall each year, but only down to 20,000.

Surely, the average value in the second case would be higher than in the first case?

The average value in the second case would be (100,000 + 20,000) / 2 = 60,000.

I hope that makes sense.

You might find the free lectures on investment appraisal useful

(and I am surprised that your lecturer did not explain to you the reason for adding the scrap value!!)

fahad says

No Sir , i m talking about deducting the scrap value from the cost of machine when you are working out total depreciation , like e.g total cashflows less total depreciation (cost – scrap value) and my lecturer didn’t deduct the scrap value from the cost of machine , the average investment part i already understood by your lectures thanks..

John Moffat says

Sorry for misunderstanding your question.

The total depreciation over the life of the machine will certainly be the initial cost less any scrap value.

I cannot think of a situation that would result in your lecturer telling you different. It seems very strange!

(He was definitely talking about ARR calculations, and not discounted cash flow calculations?)

fahad says

Thanks a lot Sir , i owe you , i have been passing all the ACCA papers of which you taught us because the way you teach is more effective , I do really enjoy your lectures and thank you for your very interesting lectures , I appreciate everything and I’ve learned a lot’ ..

John Moffat says

You are very welcome, and thanks a lot for your comments

osmanuaepak@yahoo.com says

Sir,i am from Pakistan and i understand the method of taking Average Balance Sheet Value But i have one question that,can we use the other way for taking the Average Balance Sheet value, like this one;

Add Year 1st+2nd+3rd+4th Balance Sheet Values And then Divide the Total with 4.(i have try this one and i got less then $45000)

And if not then why not we can use this Method.

ThankYou.

John Moffat says

In real life there is no rule – you can do whatever you think is more sensible. What you suggest is fine, but even then you would have to decide whether to use opening balance sheet values each year or average values each year, or closing values – each would give different answers and there is no one ‘correct’ way.

However in the exam you will be expected to do it the way in the notes and lecture (unless you were specifically told to do different, which is very unlikely).

osmanuaepak@yahoo.com says

Thank You Sir.

John Moffat says

You are welcome

Tyler says

Sir, for the A.R.R part, why do we divide by 2 for the average balance sheet value? Should we divide by 4 as it has an expected life of 4 years?

John Moffat says

Suppose that this morning you had $100 and you were spending all day so at the end of the day (10 hours later) you had nothing left.

What was the average amount of money in your pocket? Surely, on average you had $50 – you would not divide by 10 and say that it was $10.

Same example, but this time you still had $20 left at the end of the day. In that case on average you would have had more money – (100 + 20) / 2 = on average $60.

Hope that makes sense. If not then say and I will try and explain in another way

Tyler says

Yup, makes sense with the above illustration, sir. Thank you very much

John Moffat says

You are welcome

helensqq says

Hi John,

the lecture shows that payback time is 2.75 years, it’s simply add first 2 years cash inflow and a proportion of 3rd year cash inflow. However you didn’t take present value of these inflows into account. Actual payback time should be longer than 3 years if we convert these inflows to present value.

John Moffat says

But that is how we calculate the payback period – we do not discount the cash flows.

If you are asked for the ‘discounted payback period’ then you do discount the flows (and the discounted payback period will indeed be longer than the normal payback period).

sdmaalex says

Hi Sir

When we are calculating Average Book Value of the Asset, aren’t we supposed to calculate per annum? I got a bit confused and I actually calculated the depreciation in linear method. However, why do we calculate ARR in that way?

i.e. Average profit per annum from an investment/ Average Book Value of the Asset.

I would appreciate it if you could explain this a bit

Furthermore, I know this is nothing relating to PayBack Period. But don’t you think, the longer the Payback period, the lower the value of that money? As in the PV of the inflow decreses.

sdmaalex says

*decreases

John Moffat says

In real life you might be more interested in the ARR year by year. However normally in the exam we simply calculate the average. It does not matter whether we depreciate on a straight line basis or some other way – in total the depreciation will be the difference between the cost and the scrap value, which method of deprecation we use.

With regard to the payback period, what you say about the present value may well be true. However, companies use a range of measures, and one big problem with NPV’s is that the further into the future we are estimating the cash flows, the more it becomes almost a guess. The shorter the payback period, the more certain we will be that we will really get the cash back.

pamelah says

How did you get the 2.75yrs in Example 9

realhams says

you have $50000 in year two but you still need $30000 to make $80000.Therefore,30000/40000( ie the cash flows in the 3rd yr) = 0.75 yrs add 2yrs.Hope this helps

John Moffat says

Thanks Realhams – lovely explanation