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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.

johnmoffat 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.

johnmoffat 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?

johnmoffat 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

johnmoffat 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.

johnmoffat 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

johnmoffat 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

johnmoffat says

Thanks Realhams – lovely explanation