Question

• What are the principal objections to the use of the average rate of return method in evaluating capital investment proposals?

• Discuss the principal limitations of the cash payback method for evaluating capital investment proposals.

• Why would the average rate of return differ from the internal rate of return on the same project?

***Satisfactory posts are 15 points***

Answer 1

Objection of ARR method

Limitations of Using the Accounting Rate of Return – ARR

The ARR is helpful in determining the annual percentage rate of return of a project. However, the calculation has its limitations.

ARR doesn't consider the time value of money (TVM). The time value of money is the concept that money available at the present time is worth more than an identical sum in the future due to its potential earning capacity. In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.

The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.

Also, ARR does not take into account the impact of cash flow timing. Let's say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn't yield any revenue until the fourth and fifth year. The investor would need to be able to withstand the first three years without any positive cash flow from the project. The ARR calculation would not factor in the lack of cash flow in the first three years.

Limitation of payback period method

The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a break-even point.

The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.

The payback period refers to the amount of time it takes to recover the cost of an investment. Moreover, it's how long it takes for the cash flow of income from the investment to equal its initial cost. This is usually expressed in years.

Most of what happens in corporate finance involves capital budgeting — especially when it comes to the values of investments. Most corporations will use payback period analysis in order to determine whether they should undertake a particular investment. But there are drawbacks to using the payback period in capital budgeting.

Payback Period Analysis

Payback period analysis is favored for its simplicity, and can be calculated using this easy formula:

Payback Period = Initial Investment ÷ Estimated Annual Cash Flow

This analysis method is particularly helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period. The sooner money used for capital investments is replaced, the sooner it can be applied to other capital investments. A quicker payback period also reduces the risk of loss occurring from possible changes in economic or market conditions over a longer period of time.

When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment.

Some companies rely heavily on payback period analysis and only consider investments for which the payback period does not exceed a specified number of years. So, longer investment periods are typically not desired.

Limitations of Payback Period Analysis

Despite its appeal, the payback period analysis method has some significant drawbacks. The first is that it fails to take into account the time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day's earning potential.

Thus, an inflow return of $15,000 from an investment that occurs in the fifth year following the investment is viewed as having the same value as a $15,000 cash outflow that occurred in the year the investment was made despite the fact the purchasing power of $15,000 is likely significantly lower after five years.

Furthermore, the payback analysis fails to consider inflows of cash that occur beyond the payback period, thus failing to compare the overall profitability of one project as compared to another. For example, two proposed investments may have similar payback periods. But cash inflows from one project might steadily decline following the end of the payback period, while cash inflows from the other project might steadily increase for several years after the end of the payback period. Since many capital investments provide investment returns over a period of many years, this can be an important consideration.

The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.

This method also does not take into account other factors such as risk, financing or any other considerations that come into play with certain investments.

Due to its limitations, payback period analysis is sometimes used as a preliminary evaluation, and then supplemented with other evaluations, such as net present value (NPV) analysis or the internal rate of return (IRR).

ARR vs IRR

The accounting rate of return (ARR) is the percentage rate of return expected on investment or asset as compared to the initial investment cost. ARR divides the average revenue from an asset by the company's initial investment to derive the ratio or return that can be expected over the lifetime of the asset or related project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

How to Calculate the Accounting Rate of Return – ARR

1. Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
2. If the investment is a fixed asset such as property, plant, or equipment, subtract any depreciation expense from the annual revenue to achieve the annual net profit.
3. Divide the annual net profit by the initial cost of the asset, or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.

What Does ARR Tell You?

The accounting rate of return is a capital budgeting metric useful for a quick calculation of an investment's profitability. ARR is used mainly as a general comparison between multiple projects to determine the expected rate of return from each project.

ARR can be used when deciding on an investment or an acquisition. It factors in any possible annual expenses or depreciation expense that's associated with the project. Depreciation is an accounting process whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset.

Depreciation is a helpful accounting convention that allows companies not to have to expense the entire cost of a large purchase in year one, thus allowing the company to earn a profit from the asset right away, even in its first year of service. In the ARR calculation, depreciation expense and any annual costs must be subtracted from annual revenue to yield the net annual profit.

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.

What Does IRR Tell You?

You can think of the internal rate of return as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.

One popular use of IRR is comparing the profitability of establishing new operations with that of expanding existing ones. For example, an energy company may use IRR in deciding whether to open a new power plant or to renovate and expand a previously existing one. While both projects are likely to add value to the company, it is likely that one will be the more logical decision as prescribed by IRR.

IRR is also useful for corporations in evaluating stock buyback programs. Clearly, if a company allocates a substantial amount to a stock buyback, the analysis must show that the company's own stock is a better investment (has a higher IRR) than any other use of the funds for other capital projects, or higher than any acquisition candidate at current market prices.