BUSF_A01.qxd

Accounting (unadjusted) rate of return

project will end prematurely. It ignores such risks as sales revenues being less than

anticipated or costs being greater than planned.

We may generally conclude that PBP is not a very good method for selecting

investment projects, and its use is likely to lead to sub-optimal decisions. It can,

however, give insights into projects that the NPV method fails to provide, particularly

on the question of liquidity. Thus the PBP method is seen by some as a useful com-

plement to NPV.

4.5 Accounting (unadjusted) rate of return

The accounting rate of return(ARR) compares the average annual profit increase,

after taking the cost of making the initial investment into account, with the amount of

the initial investment. The outcome is usually expressed as a percentage.

Some users of ARR define it as average profit divided by averageinvestment.

Provided that the definition adopted is consistently applied, neither is superior to the

other.

For the two opportunities in Example 4.1, and using the first definition of the ARR,

for Zenith it would be

÷20,000 =9.0%

(The £20,000 is deducted from the total annual savings to take account of the cost of

the depreciation of the machine over the five years.)

For Super it would be

÷25,000 =6.4%

The decision rule would be that projects would only be accepted where they are

expected to yield an ARR higher than some predetermined rate. With competing

projects, the one with the higher ARR (Zenith in this case) would be selected. It should

be noted particularly that ARR deals with accounting flows, notwith cash flows. This

is to say that ARR looks at the effect on future reported profits that a particular pro-

ject will cause.

Although in Example 4.1 it has been assumed that, apart from depreciation, cash

flows and accounting flows arising from the purchase of either of the presses (Zenith

or Super) are the same for the years concerned, this will not always be the case for all

projects to be assessed, as is explained in Chapter 5.

ARR is also known as the unadjusted rate of returnand as return on investment

(ROI).

Comparison of ARR and NPV methods

l ARR does not relate directly to wealth maximisation but pursues maximisation of

a rate of return measured by accounting profits.

(8,000 +6,000 +5,000 +6,000 +8,000) −25,000

5

(4,000 +6,000 +6,000 +7,000 +6,000) −20,000

5

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