Welcome to Finance and Excel video number 72.
Hey, if you want to download this workbook, chapter 8,
click on the link directly below the video
and scroll all the way down to the Finance Excel class
section.
Hey, we're talking about investment criteria,
whether or not we should invest in the asset we've looked at,
net present value and payback.
Now, we're going to look at the average accounting return.
There are many different definitions, here's one--
got to calculate the average net income--
so calculate the net income for each period--
and then calculate an average, and then
divided by the average book value.
This sort of looks like return on assets.
In chapter 3, we did net income divided by the asset value.
And for that reason, there are--
well, no, not for that reason.
There are other ways to calculate average accounting
return besides just this.
Some people just take the return on assets for each year
and then average them.
Now, the steps, for us, are going to be--
estimate all revenues and expenses
over the life of the asset, calculate
the net income for each year, estimate the book value.
Now, book value is whatever the historical cost
is, subtract out all your accumulated depreciation.
So estimate the book value over the life of the asset.
And then we're going to calculate an average book
value.
Because, remember, that's going to be the denominator.
We also are going to have to decide, in advance,
the target cutoff AAR rate.
So this is the rate.
Anything above this, we're going to accept.
Anything below it, we're not going to accept.
So this is the rate we want.
This is the average accounting rate we actually want.
Decision rule-- accept the project of calculated AAR
is greater than the cutoff.
So this cutoff is like the hurdle.
Anything above it, we're going to accept it.
Now, this is using accounting information right--
as good as cash flow information.
Financial managers, usually they like to deal with cash flows.
So that's a big downside to this measure.
However, people do use this, because accounting information
is usually easy to get.
All right, let's see how to do this.
We've estimated-- this is the same, exact example we
did for net present value and payback,
except for when we looked at this slide
before, we knew that these were the calculated amounts
and this was the average book value.
So now, we're going to actually see how to calculate.
So we've estimated.
There's the revenue.
There's the expenses.
And these are all expenses, including depreciation to tax.
So we will calculate our net income for each year--
all the revenues minus all of the expenses.
Control-Enter, and I'm going to drag that over.
Now, average-- we're going to use the average function.
Adds them all up, divides by the count.
So add then all up, divided by 3.
So that's the average net income over the life of this project
here.
Now, book value-- well, first we need
to calculate our depreciation.
And depreciation, the idea behind depreciation--
I know this is not an accounting class, but it's simple--
$180,000 for the original cost.
If you took that as an expense in the first year,
the expense would be too big, because this asset's
going to last over three years.
So the idea is you've got to chop it into three pieces
and put some in each year.
All right.
So one way to do depreciation is straight line.
And we're going to assume that at the end of three years,
it'll have no value.
So the salvage value is 0.
So here's our depreciation calculation--
original cost minus the salvage, divided by the number of years.
And that's how much we're going to take each year.
Now, book value-- well, at time 0, what's the book value?
This.
Now, after one year, the accumulated depreciation,
there is a depreciation expense which hits the income
statement, and there's also a balance sheet account called
accumulated depreciation.
And so at the end of one year, we
take the original historical cost
and subtract the accumulated depreciation.
Now, here it's minus 60,000.
And you imagine, if you were looking at the accumulated
depreciation account at the end of year two,
it would say 120, because there's been
two years where we took 60,000.
But for this calculation, we're trying
to figure out the book value.
So this, this--
I'm just going to say whatever the book value
from last period minus that.
And I'm going to hit the F4 key to lock it.
So right now, we could see 120 minus 60.
That means the balance will be this.
When I copy this over, of course, we're going to get 0.
Now, you take the average.
And the reason I'm showing you this calculation--
there's an easier way to do average book
value when you have a straight line
and it goes down to 0 here.
But I'm showing you how to do it each year,
because if you don't have straight line depreciation
method, then you've got to calculate your book value--
whatever calculation--
for each individual year--
whatever those calculations are-- and then
you average them.
So 90,000.
Now, the easy way to do this is to,
given that we have straight line down to zero, simply say,
that divided by 2.
In all the examples in this textbook,
that's what they'll give you.
But that long method gets you the same thing.
And if, for some reason, there's a different depreciation
method than straight line, that will work.
Now, we have our numbers.
We have average net income, average book value.
We can simply divide the two.
This kind of like return on assets.
Here's the average return over in accounting numbers
over the project, Here's the average book value
over the period.
And, boom.
So we get an AAR of 0.2148.
Our target hurdle is 25.
So, no way.
We reject project.
All right.
Now, of course, the problems are many with the account.
Average accounting rate rule does not
adjust for the time value of money.
Rule does not adjust for risk.
Meaning, as we saw with net present value,
the discount rate or required rate of return
would include the risk.
And rule does not provide information
on whether we create value or not.
The only advantage is some people
say, well, the accounting information is easy to get,
whereas the cash flow information may
be a little bit harder to get than, say, the accounting.
But this is all riddled with estimations.
Again, we're estimating into the future, so it does seem like,
might as well do the net present value method.
Nevertheless, some people do do this.
And, to reiterate what I said earlier,
people use multiple decision criteria.
So they might do net present value.
This accounting rate of return, and payback, or something
like that.
When we come back in the next video,
we'll actually talk about the IRR--
the Internal Rate of Return-- closely related
to net present value.
All right, see you next video.