Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

book value of $25 million ([$50 – $0] ÷ 2), an
average net income of $15.4 million ([$8 + $12

• $15 + $20 + $22] ÷ 5), and an accounting
  rate of return of 61.6% ($15.4 ÷ $25). Because
  both projects earn more than the required 25%

minimum return, Global Untethered should be

willing to invest in either project, and it would rank

the South-eastern Australia investment above the

Western Europe expansion.

example

9-3b PROS AND CONS OF THE ACCOUNTING RATE OF RETURN

Because of their convenience, ease of calculation and ease of interpretation, accounting-based measures

are used by many companies to evaluate capital investments. However, these techniques have serious

flaws:

■ As the preceding example demonstrates, the decision about what depreciation method to use has

a large effect on both the numerator and the denominator of the accounting rate of return formula.

■ This method makes no adjustment for the time value of money or project risk.

■ Investors should be more concerned with the market value than the book value of the assets that a

company holds. After five years, the book value of Global Untethered’s investment (in either project)

is zero, but the market value will almost certainly be positive, and may be even greater than the initial

amount invested.

■ As explained in Chapter 2, finance theory teaches that investors should focus on a company’s ability

to generate cash flow rather than on its net income.

■ The choice of the 25% accounting return hurdle rate is essentially arbitrary. This rate is not based on

rates available on similar investments in the market, but reflects a purely subjective judgement on

the part of management.

By now you may have noticed some common themes in our discussion of the pros and cons of different

approaches to capital budgeting. None of the methods discussed thus far considers all of a project’s cash

flows in the decision-making process. Each of these methods fails to properly account for the time value

of money, and none of them deals adequately with risk. Most importantly, none of the methods discussed

so far is consistent with the goal of shareholder wealth maximisation. We now turn our attention to a

method that solves all these difficulties and therefore enjoys widespread support from both academics

and business practitioners.

4 Why do managers focus on the effect that an investment will have on reported earnings rather than

on the investment’s cash flow consequences?

5 What factors determine whether the annual accounting rate of return on a given project will be

high or low in the early years of the investment’s life? In the latter years?

CONCEPT REVIEW QUESTIONS 9-3