Accounting Rate of Return Method of Capital Budgeting

TORAN LAL VERMA

Accounting rate of return method is also called  financial statement method or unadjusted rate of return method.

Decision Criteria

  1. In case of many projects, a project with higher ARR or NOI will be selected.
  2. In case of only one project, it would be selected if it earns more than companies predetermined required rate of return.

Advantages of Accounting Rate of Return Method

  1. It is simple and easy to calculate.
  2. It takes into account all the savings over the entire period of economic life of the investment.
  3. It is based on accounting profit rather than cash inflow. Accounting profit can be easily obtained from financial statements.
  4. It measures the benefit in percentage which makes it easier to compare with other projects.
  5. This method helps to distinguish between projects, where the timing of savings is approximately the same.

Disadvantages of Accounting Rate of Return Method

  1. This method ignores the time value of money.
  2. This method is based on accounting profits rather than cash flows. In order to maximize the wealth of shareholders, cash flows should be taken for calculation
  3. This method ignores the size of investment. Sometimes ARR may be the same for different projects but some of them may involve huge cash flows.
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