Page 126 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

2. Whenever it is clearly mentioned as average rate of return Notes

If Average rate of return is given in the Illustration, return on average investment method
should be used to calculate average rate of return.
AverageannualEAT
Average Rate of Return = × 100
()*
Averageinvestment AI
* AI = (Original investment – scrap)1/2 + Additional NWC + Scrap value
?

Did u know? What will be the accounting treatment if ARR is given in problem?
If ARR is given in the problem, any one of the above method can be used to calculate ARR
(preferably return on average investment method).
Accept-Reject Rule

Acceptance or rejection of the project is based on the comparison of calculated ARR with the
predetermined rate or cut of rate.
Accept: Cal ARR > Predetermined ARR or Cut-off rate
Reject: Cal ARR < Predetermined ARR or Cut-off rate

Considered: Cal ARR = Predetermined ARR or Cut-off rate

Advantages of ARR Method

The ARR method has some merits.
1. The most significant merit of ARR is that, it is very simple to understand and easy to

calculate.
2. Information can easily be drawn from accounting records.
3. It takes into account all profits of the projects’ life period.

4. Cost involvement in calculating pay back period is very less in comparison to the
sophisticated methods, since it saves analysts’ time.
Limitations of ARR Method

ARR method suffers form serious demerits.

1. It uses accounting profits instead of actual cash flows after taxes, in evaluating the projects.
Accounting profits are inappropriate for evaluating and accepting projects, since they are

computed based on arbitrary assumptions and choices and also include non-cash items.
2. It ignores the concept of time value of money.
3. It does not allow profits to be reinvested.

4. It does not differentiate between the size of the investment required for each project.

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