Question

magine your department is responsible for evaluating potential capital investment projects and you must establish the method and criteria by which projects will be selected. Further assume that your boss thinks NPV analysis is too complicated for most lower management decisions and has directed you to use a method other than NPV. Select one of the other evaluation techniques (Investment Rules) and discuss its merits. In your discussion, address how you might minimize any of the "drawbacks" of your selected method.

Answer 1

Accounting or average rate of return is a method of capital budgeting or a method of evaluating the investment proposal. It is a method in which after tax profit is considered as a percentage of total investment. This method gives a rate of return which can be earned. Formula for calculating the Accounting rate of return:

Accounting rate of return = average profit/ initial investment

Decision criteria related to average rate of return is that if ARR is greater than required rate of return, project would be accepted and if it is less than the required rate of return, it should not be accepted.

Merits of ARR methods are (1) It is simple to calculate and understand (2) it takes into account the after tax profit earned by business which can be easily obtained from the expected income or profits of the company.

In case of accounting rate of return we can use the projected free cash flow to estimate the rate of return rather than the after tax profit, because cash flow will give more accurate results as business or projects involves many of cash flows. while after tax profit ignores the other cash flows.