Accounting Rate of Return Approach

Question 1

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

Answer 1

1. Easy to use and understand
2. Consistent with financial statement values
3. Considers entire life and results of project

Question 2

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

Answer 2

1. Ignores the time value of money

2. Uses accrual accounting values, not cash flows

Question 3

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

Answer 3

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 4

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

Answer 4

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

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, rather than when the initial investment is used.