Accounting rate of return method
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 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 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:
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. 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: 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: Required: Using accounting rate of return...
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