There can be other reasons, apart from depreciation, as to why the profit might be different from the cash inflow such as the not all sales are cash-based, some of them are on credit as well. Is my understanding correct? If yes then shouldn’t we have to account for them as well?

Hello! My question is that why do we add the scrap value to the initial investment while calculating the average investment for the calculation of average rate of return?

If an asset cost 10,000 and ends up being worth zero, then the average value is 5,000.
If an asset costs 10,000 and ends up still being worth 1,000, then the average value must be higher! It is (10,000 + 1,000) / 2 = 5,500.

Dear John,
when we calculate the average investment of balance sheet for ARR calculation, why we simply divided by 2, why not by total numbers of years ?
I am sorry if its a silly question to u!!!!!! but i really didnt get it. thank you.

Just imagine that you started the week with $100 in your pocket and ended the week with only $10 in your pocket.

How much did you have on average in your pocket? Surely on average you had (100+10)/2 = $55. (You would not divide by 7 because there are 7 days in the week).

It is the same principle for ARR – to get the average value of the investment.

While calculating average profit p.a.
Total operating cash flows is 100,000. here we have not added the scrap value of $10,000; like we did in finding net present value.

Could you please explain why we don’t take into account scrap value when calculating the average profit? When we sell the machine at the end of 4 year we will get the $10 000 for it. This is our income.

Also I have two more questions. Unfortunately, I cann’t find link to forum, that’s why I write them here.
I’ve made practise question 6 Gold.

1. In answers payback period is calculated as = 4 + 1/8 = 4.125. How you get 1/8? I calculated it as = 4 + 1000/23000 (cash flow for year 5) = 4.04.

2. I don’t agree with the answer b, part ii.
The question is “Is it worth equipping the new premises”.
In answers you take the market value of the new premises into consideration.
But for me – market value is not a cash flow and it doesn’t depend on the way of equipment. I think that market value is irrelevant information. And also it’s told that Bronze has recently expanded into new premises. This means Bronze has already bought it.

1. The cash flow in year 5 is 8,000 (the 15,000 will not come until the very end of the year).

2. They have indeed already bought new premises. However, they are deciding whether or not to move into them. If they don’t move in then they sell them for 2.6M, so it is an opportunity cost of using them.

In future, you must ask in the forums or questions other than on the lectures will not be answered. There is a tab at the top of the page that says on it ‘ACCA Forums’!!

You have said that if he cast the depreciation, I am a little confused that how you took 80,000 did you just assumed it or the examiner would tell us what value to use , If you give some explanation on this it would be very nice of you .

Thank You I am getting F9 lectures very easily and I can understand them all credit goes to you .

The total depreciation is the difference between the initial cost and the scrap value (both of which are given in the question – I assume that you have downloaded the Course Notes?).

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 ..

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!!)

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..

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?)

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’ ..

Arun says

Hello John,

There can be other reasons, apart from depreciation, as to why the profit might be different from the cash inflow such as the not all sales are cash-based, some of them are on credit as well. Is my understanding correct? If yes then shouldn’t we have to account for them as well?

Thanks.

John Moffat says

Your understanding is correct.

However we never account separately in DCF calculations for receivables etc. (But they are effectively dealt with in the working capital cash flows).

zaineb15 says

Hello! My question is that why do we add the scrap value to the initial investment while calculating the average investment for the calculation of average rate of return?

John Moffat says

If an asset cost 10,000 and ends up being worth zero, then the average value is 5,000.

If an asset costs 10,000 and ends up still being worth 1,000, then the average value must be higher! It is (10,000 + 1,000) / 2 = 5,500.

yetunde says

Thank you as always,you have made investment appraisal look soo easy,

merci beaucoup!

arman90fy says

Dear John,

when we calculate the average investment of balance sheet for ARR calculation, why we simply divided by 2, why not by total numbers of years ?

I am sorry if its a silly question to u!!!!!! but i really didnt get it. thank you.

John Moffat says

Just imagine that you started the week with $100 in your pocket and ended the week with only $10 in your pocket.

How much did you have on average in your pocket? Surely on average you had (100+10)/2 = $55. (You would not divide by 7 because there are 7 days in the week).

It is the same principle for ARR – to get the average value of the investment.

arman90fy says

Dear john, thank you so much for your very simple convenient example….:)

aliimranacca007 says

Pay back period how u take .75 in 2.75

John Moffat says

After 2 years they have got back 50,000. So they need another 30,000. There is 40,000 in the third year, so 30,000 is 3/4 (or 0.85) of 40,000.

Amit says

While calculating average profit p.a.

Total operating cash flows is 100,000. here we have not added the scrap value of $10,000; like we did in finding net present value.

Amit says

Sincerely sorry sir, this query has already been addressed.

Tatiana says

Hello, Sir!

Could you please explain why we don’t take into account scrap value when calculating the average profit? When we sell the machine at the end of 4 year we will get the $10 000 for it. This is our income.

John Moffat says

Scrap proceeds never appear in profit statements (they do not when we do financial accounts, and ARR is an accounting measure)!!!

We take them into account when we calculate the deprecation, which does appear in the Statement of profit or loss.

Tatiana says

Thank you very much, Mr Moffat.

Also I have two more questions. Unfortunately, I cann’t find link to forum, that’s why I write them here.

I’ve made practise question 6 Gold.

1. In answers payback period is calculated as = 4 + 1/8 = 4.125. How you get 1/8? I calculated it as = 4 + 1000/23000 (cash flow for year 5) = 4.04.

2. I don’t agree with the answer b, part ii.

The question is “Is it worth equipping the new premises”.

In answers you take the market value of the new premises into consideration.

But for me – market value is not a cash flow and it doesn’t depend on the way of equipment. I think that market value is irrelevant information. And also it’s told that Bronze has recently expanded into new premises. This means Bronze has already bought it.

John Moffat says

1. The cash flow in year 5 is 8,000 (the 15,000 will not come until the very end of the year).

2. They have indeed already bought new premises. However, they are deciding whether or not to move into them. If they don’t move in then they sell them for 2.6M, so it is an opportunity cost of using them.

In future, you must ask in the forums or questions other than on the lectures will not be answered. There is a tab at the top of the page that says on it ‘ACCA Forums’!!

Tatiana says

Thank you very much. I think I see your point.

Ahmad Masood Faqiri says

Dear John Sir,

You have said that if he cast the depreciation, I am a little confused that how you took 80,000 did you just assumed it or the examiner would tell us what value to use , If you give some explanation on this it would be very nice of you .

Thank You I am getting F9 lectures very easily and I can understand them all credit goes to you .

Thanks

John Moffat says

The total depreciation is the difference between the initial cost and the scrap value (both of which are given in the question – I assume that you have downloaded the Course Notes?).

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