Accounting Rate of return

If you have already studied other capital budgeting methods (net present value method, internal rate
of return method and payback method), you may have noticed that all these methods focus on cash
flows. But accounting rate of return (ARR) method uses expected net operating income to be
generated by the investment proposal rather than focusing on cash flows to evaluate an investment
proposal.
Under this method, the asset’s expected accounting rate of return (ARR) is computed by dividing the
expected incremental net operating income by the initial investment and then compared to the
management’s desired rate of return to accept or reject a proposal. If the asset’s expected accounting
rate of return is greater than or equal to the management’s desired rate of return, the proposal is
accepted. Otherwise, it is rejected. The accounting rate of return is computed using the following
formula:
Formula of accounting rate of return (ARR):

In the above formula, the incremental net operating income is equal to incremental revenues to be
generated by the asset less incremental operating expenses. The incremental operating expenses
also include depreciation of the asset.
The denominator in the formula is the amount of investment initially required to purchase the asset. If
an old asset is replaced with a new one, the amount of initial investment would be reduced by any
proceeds realized from the sale of old equipment.
Example 1:
The Fine Clothing Factory wants to replace an old machine with a new one. The old machine can be
sold to a small factory for $10,000. The new machine would increase annual revenue by $150,000
and annual operating expenses by $60,000. The new machine would cost $360,000. The estimated
useful life of the machine is 12 years with zero salvage value.
Required:
1. Compute accounting rate of return (ARR) of the machine using above information.
2. Should Fine Clothing Factory purchase the machine if management wants an accounting rate of
return of 15% on all capital investments?
Solution:
(1): Computation of accounting rate of return:

= $60,000* / $350,000**
= 17.14%
*Incremental net operating income:
Incremental revenues – Incremental expenses including depreciation
$150,000 – ($60,000 cash operating expenses + $30,000 depreciation)
$150,000 – $90,000
$60,000
** The amount of initial investment has been reduced by net realizable value of the old machine
($360,000 – $10,000).
 (2). Conclusion:
According to accounting rate of return method, the Fine Clothing Factory should purchases the
machine because its estimated accounting rate of return is 17.14% which is greater than the
management’s desired rate of return of 15%.
Cost reduction projects:
The accounting rate of return method is equally beneficial to evaluate cost reduction projects. The
accounting rate of return of the assets that are purchased with a view to reduce business costs is
computed using the following formula:

Example 2:
The P & G company is considering to purchase an equipment costing $45,000 to be used in packing
department. It would reduce annual labor cost by $12,000. The useful life of the equipment would be
15 years with no salvage value. The operating expenses of the equipment other than depreciation
would be $3,000 per year.
Required: Compute accounting rate of return/simple rate of return of the equipment.
Solution:

= $6,000* / $45,000
= 13.33%
*Net cost savings:
$12,000 – ($3,000 cash operating expenses + $3,000 depreciation expenses)
$12,000 – $6,000
$6,000
Comparison of different alternatives:
If several investments are proposed and the management have to choose the best due to limited
funds, the proposal with the highest accounting rate of return is preferred. Consider the following
example:
Example 3:
The Good Year manufacturing company has the following different alternative investment proposals:
Proposal A Proposal B Proposal C
Expected incremental income per year (a) $50,000 $75,000 90,000
Initial investment (b) $250,000 $300,000 $500,000
Expected accounting rate of return (a)/(b) 20% 25% 18%
Required: Using accounting rate of return method, select the best investment proposal for the
company.
Solution:
If only accounting rate of return is considered, the proposal B is the best proposal for Good Year
manufacturing company because its expected accounting rate of return is the highest among three
proposals.
Advantages and disadvantages:
Advantages:
1. Accounting rate of return is simple and straightforward to compute.
2. It focuses on accounting net operating income. Creditors and investors use accounting net operating
income to evaluate the performance of management.
Disadvantages:
1. Accounting rate of return method does not take into account the time value of money. Under this
method a dollar in hand and a dollar to be received in future are considered of equal value.
2. Cash is very important for every business. If an investment quickly generates cash inflow, the
company can invest in other profitable projects. But accounting rate of return method focus on
accounting net operating income rather than cash flow.
3. The accounting rate of return does not remain constant over useful life for many projects. A project
may, therefore, look desirable in one period but undesirable in another period.

NPV ( Net Present Value)

Wellness company is trying to choose the best investment project from two alternative projects. The
company has $30,000 to invest. The information about two alternatives is given below:
project X project Y
Investment required $30,000 $30,000
Annual cash inflows $8,000 0
Single cash inflow at the end of 8 years – $120,000
Project life 8 years 8 years
The discount rate of Wellness company is 15%.
Required: Give your recommendations to the company in selecting the best project to invest
$30,000. Usenet present value method for your answer.
Solution:
Net present value of project X:
Amount of Present value
Years 15% Factor
cash flows of cash flows
Cash inflow 1–8 $8,000 4.487* $35,896
Investment required Now $(30,000) 1.000 $(30,000)
———–
$5,896
Net present value ———–
Net present value of project Y:
Amount of Present value
Years 15% Factor
cash flows of cash flows
Cash inflow 8 $120,000 0.327* $39,240
Investment required Now $(30,000) 1.000 $(30,000)
———–
Net present value $9,240
———–
Recommendations: Project Y’s net present value is $9,240 which is more than project X’s net
present value. Project Y is therefore, more desirable.
Internal Rate of Return

Fast Carriage Company is considering to purchase a large truck. The expected useful life of the truck
is 14 years. The cost and net cash inflow associated with the new truck is as follows:
Cost of new truck $273,400
Expected annual net cash inflow $50,000
Required: Compute internal rate of return of the truck. Is the investment in truck desirable if
management wants a 15% return on all such investments?
Solution:
Step 1 Computation of internal rate of return factor:
The first step is to compute internal rate of return factor by dividing investment required to purchase
truck by net annual cash inflows.

= $273,400/$50,000
= 5.468
Step 2 Finding the internal rate of return promised by truck:
We would search for the factor (5.468) computed in step 1 in “present value of an annuity of $1 in
arrears table”. In 14-period line, we can see that 5.468 factor represents a 16% rate of return. The
internal rate of return of the truck is, therefore, 16%.
Step 3 Comparing truck’s rate of return and management’s desired rate of
return:
As the internal rate of return of the truck (16%) found in step 2 is greater than the management’s
desired rate of return (15%), the investment in new truck is desirable.

Payback Method

Unlike net present value method and internal rate of return method, payback method does not
consider the present value of cash flows. Under this method, an investment project is accepted or
rejected on the basis of payback period. Payback period means the period of time that a project
requires to recover the money invested in it. The payback period of a project is expressed in years
and is computed using the following formula:
Formula of payback period:

According to this method, the project that promises a quick recovery of initial investment is considered
desirable. If the payback period of a project computed by the above formula is shorter than or equal to
the management’s maximum desired payback period, the project is accepted otherwise it is rejected.
For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the
maximum desired payback period of the company would be 5 years. The purchase of machine would
be desirable if it promises a payback period of 5 years or less.
Consider the following example to understand the analysis of a project under this method:
Example 1:
Due to increased demand, the management of Rani Beverage Company is considering to purchase a
new equipment to increase the production and revenues. The useful life of the equipment is 10 years
and the company’s maximum desired payback period is 4 years. The inflow and outflow of cash
associated with the new equipment is given below:
The initial cost of equipment $37,500
Annual cash inflow:
Sales $75,000
Annual cash outflow:
Cost of ingredients $45,000
Salaries expenses $13,500
Maintenance expenses $1,500
Non cash expenses:
Depreciation $5,000
Required: Should Rani Beverage Company purchase the new equipment? Use payback method for
your answer.
Solution:
Step 1: In order to compute the payback period of the equipment, we need to workout the net annual
cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the
equipment.
Computation of net annual cash inflow:
$75,000 – ($45,000 + $13,500 + $1,500)
= $15,000
Step 2: Now, the amount of investment required to purchase the equipment would be divided by the
amount of net annual cash inflow (computed in step 1) to find the payback period of the equipment.

= $37,500/$15,000
=2.5 years
Depreciation is a non cash expense and therefore has been ignored.
According to payback method, the equipment should be purchased because the payback period of
the equipment is 2.5 years which is shorter than the maximum desired payback period of the
company.
Comparison of two or more alternatives – choosing from several
alternative projects:
Where funds are limited and several alternative projects are being considered, the project with the
shortest payback period is preferred. It is explained with the help of the following example:
Example 2:
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new
machine. Two types of machines are available in the market – machine X and machine Y. Machine X
would cost $18,000 where as machine Y would cost $15,000. Both the machines can reduce annual
labor cost by $3,000.
Required: Which is the best machine to purchase according to payback method?
 Solution:
Machine X Machine Y
Cost of machine (a) $18,000 $15,000
Annual cost saving (b) $3,000 $3,000
Payback period (a)/(b) 6 years 5 years
According to payback method, machine Y is more desirable than machine X because it has a shorter
payback period than machine X.
Payback method and uneven cash flow:
In the above examples we have assumed that the projects generate even cash inflow (same cash
inflow during each period) but when projects generate uneven cash inflow (different cash inflow in
different periods), the payback period formula given above cannot be used to compute payback
period.
To understand the analysis of a project that generates uneven cash inflow, consider the following
example:
Example 3:
An investment of $200,000 is expected to generate the following cash flows in six years:
Year Net cash flow
1 $30,000
2 $40,000
3 $60,000
4 $70,000
5 $55,000
6 $45,000
Required: Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?
Solution:
(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the
payback period. We can compute the payback period by computing the cumulative net cash flow as
follows:
Net cash Cumulative net cash
Year
flow inflow
1 $30,000 $30,000
2 $40,000 $70,000
3 $60,000 $130,000
4 $70,000 $200,000
5 $55,000 $255,000
6 $45,000 $300,000
Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal to
initial amount of investment.
(2). As the payback period is longer than the maximum desired payback period of the management (3
years), the investment should not be made.
Advantages and disadvantages of payback method:
Advantages:
1. An investment project with a short payback period promises the quick inflow of cash. It is therefore, a
useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the business quickly. The
payback period is important for the firms for which liquidity is very important.
3. An investment with short payback period makes the funds available soon to invest in another project.
4. A short payback period reduces the risk of loss caused by changing economic conditions and other
unavoidable reasons.
5. Payback period is very easy to compute.
Disadvantages:
1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback period. For example,
If two projects, project A and project B require an initial investment of $5,000. Project A generates an
annual cash inflow of $1,000 for 5 years whereas project B generates a cash inflow of $1,000 for 7
years. It is clear that the project B is more profitable than project A. But according to payback method,
both the projects are equally desirable because both have a payback period of 5 years
($5,000/$1,000).