Investment Appraisal Techniques: Accounting Rate of Return

Published by slang April 8th, 2006 in Long-Term Decisions

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There are many investment appraisal techniques.

Today’s article is confined to the discussion of the Accounting Rate of Return Method or Accounting Return on Book Value. First, we shall go thro’ an illustration to demonstrate how it’s being calculated and then go on with the discussion on its advantages and disadvantages.

Incidentally, the Accounting rate of return is very commonly used as this concept is a very familiar concept to return on investment (ROI), return on capital employed(ROCE) or accounting rate of return(ARR).

The formula for this method is Average Annual Income/Average Annual Investment

Illustration:

Let’s say we are evaluating the below said project with the following Initial Outlay/Investment and Net Cash flow ( Revenue minus Costs)

Investment:

	Year 0	Year 1	Year 2	Year 3	Average
Gross Book Value of Investment	100,000	100,000	100,000	100,000
Depreciation		20,000	20,000	20,000
Accumulated Depreciation		20,000	40,000	60,000
Net Book Value	100,000	80,000	60,000	40,000	70,000

Returns/Net “Cash flow (Revenue-Costs)

	Year 1	Year 2	Year 3	Average
Revenue(a)	50,000	70,000	100,000
Costs (b)	20,000	30,000	40,000
Cashflow (a-b)	30,000	40,000	60,000
Depreciation	20,000	20,000	20,000
Net profit	10,000	20,000	40,000	23,300

Accounting Rate of Return = Average annual returns

Average annual investments

= $23,300

$70,000

= 33.3%

What are then the Pro’s and Con’s of ARR:

Pro’s	Con’s
It takes all the years into account when making an investment decision,	There is no account of *time value of money*. It does not take into account the fact that dollars to be received in the future is not worth as much as money in the hand today.
It’s is easy to use and is familiar concept to managers which they refer to as “ return on investment” or “ return on Capital employed.	It is purely based on *accounting figures* and not on cash flow. Thus it Does not take into account the *working capital requirements* that are needed for the investment as working capital is not captured in accounting profit, can be *manipulated by changing accounting methods like depreciation rates & methods* which have nothing to do with the underlying investment.
	Having calculated the return, we still do not know *whether the return is acceptable or not*? Perhaps, we can compare it to other companies in the industry. But don’t forget that the other companies might be using different accounting convention, Secondly, high accounting rate of return, the project or investment can be rejected because this cannot be compared to other past returns. This is despite that the high returns are still profitable to the company.

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