Accounting Rate of Return Approach

Question 1

Describe the accounting rate-of-return (also called the simple rate of return) approach to capital project evaluation.

Answer 1

Measures the expected average annual incremental accounting income from a project as a percentage of the initial (or average) investment and compares that with the established minimum rate required.

Question 2

What are the advantages of the accounting rate-of-return approach to project evaluation?

Answer 2

• It is easy to use and understand.
• It is consistent with financial statement values.
• It considers the entire life and results of the project.

Question 3

What are the disadvantages of the accounting rate-of-return approach to project evaluation?

Answer 3

• It ignores the time value of money.
• It uses accrual accounting values, not cash flows.
• The use of different depreciation methods will give different results for projects.

Question 4

What alternative investment bases can be used in the accounting rate-of-return approach (to capital budgeting)?

Answer 4

Two alternative investment bases may be used:

1. Initial investment.
2. Average investment (i.e., the average book value of the asset over its life)

Question 5

In computing the accounting rate-of-return approach (to capital budgeting), will using the initial investment or the average investment give the higher rate of return?

Answer 5

Because the average investment gives a smaller denominator, the accounting rate of return will be higher when the average investment is used than when the initial investment is used.