Question

8.3a What is an average accounting rate of return, or AAR?

8.3b What are the weaknesses of the AAR rule?

Answer 1

AAR (Average rate of return) is a simple or traditional or non discounting method of capital budgeting. This method calculates the average net profits during the life of the project as a percentage return on capital Invested. Unlike other methods of capital budgeting, this is the only method that uses accounting profits instead of cash flows.

AAR = Average profits after tax / Average Investment * 100

Such profits are to be taken after deducting for depreciation and taxes. This method is generally suitable for appriasal of small projects or non critical projects.

Question 8.3 (b)

Weaknesses of AAR rule

(1) Use of accounting profits in the place of cashflows does not make accurate comparision with Investments. That means, while investment represents cash out flow, profits does not represents cash in flows. so a comparison does not hold good.

(2) Another major defficiency is not using the time value concept. Every profit, whether it is year - 1 or Year - 15 shall be taken with same weightage. But in financial terms, one cannot give equal importance, due to decreasing value of dollar with delay in its receipt.

(3) Multiple practices in defining or choosing the denominator does not make the AAR universal measurement. Investment in the denominator is taken as average ( i.e Investment / 2 ) and in come cases it is taken in full. If there are working capital and salvage value, determination of denominator becomes complicated and accountants tends to apply different approaches.

(4) Long term projects - in general should not be appraised based on this method. This method gives a rough idea about profit potential, such that it helps in preliminary screening of large number of alternatives.