Evaluation and Techniques - Accounting Rate of Return

Question 1

Accounting Rate of Return

Answer 1

Simple Rate of Return - Assesses a project by leasing the expected annual incremental income from the project a a percent of the initial investment

ARR = (AVERAGE ANNUAL INCREMENTAL REVENUES - AVERAGE ANNUAL INCREMENTAL EXPENSES) / Initial ( or average) investment

Question 2

Special Considerations

Answer 2

Depreciation expense is recognized; this method is based on expected accounting revenues and expenses, only accounting rate of return method that recognizes depreciation.

Income Tax are recognized because tax affects income

Residual value is taken into account to the extent it generates an increase from a gain or decrease from a loss upon disposal

Question 3

Advantages and Disadvantages

Answer 3

A.
Advantages –
1. Easy to understand and use
2. Consistent with financial statement values
3. Considers entire life and results of project
B.
Disadvantages –
1. Ignores the time value of money (i.e., present value of future net profits or losses.)
2. Uses accrual accounting values, not cash flows.
3. Use of different depreciation methods will give different results for projects.