Chapter 4 • Investment appraisal methods
l ARR almost completely ignores the timing of the cash flows and hence the fin-
ancing cost. The above ARRs for the Zenith and the Super would be identical irres-
pective of when within the five years they fell, provided that they had the same
totals. With the Zenith, for example, the alternative cash flows shown below would
give the same ARR as the original ones.Year Original Alternative
££
0 (20,000) (20,000)
1 4,000 25,000
2 6,000 1,000
3 6,000 1,000
4 7,000 1,000
5 6,000 1,000Any rational investor would prefer the alternative, yet ARR cannot distinguish
between them. The method makes no attempt to adjust the cash flows to reflect
their timing.
l Typically, all relevant information on the cash flows (except their timing) is used in
arriving at the ARR of an investment prospect. However, ARR often picks up some
irrelevant data as well. This is because accounting profit is calculated on a basis
that, for example, apportions a share of overheads to a particular project, even
where the overheads do not vary according to whether or not the project is under-
taken. In practice, it can be misleading to use accounting information to make deci-
sions about the future in the way that the ARR approach does. This is not to say that
measuring accounting profit is not a useful activity, simply that it is not a useful
approach to assessing future real investment opportunities.
l ARR is easy to use, but the fact that it can be defined in two different ways can lead
to confusion.
Like the PBP method, ARR seems likely to lead to poor decisions. Also, like PBP,
there is the question of how the business arrives at a minimum ARR that it is prepared
to accept. One of its features is the fact that it does not reflect repayments of the
original investment. Take, for example, the ‘alternative’ cash flows for the Zenith
given above. Here all of the original investment would be repaid in the first year, and
it is thus a very attractive investment with a very high rate of return. Yet despite this,
if the devotee of ARR decided to use the cost of borrowing (say 12 per cent) as the hur-
dle rate, the project would be rejected because its ARR is only 9 per cent. Perhaps,
more logically, the return on capital employed (ROCE) ratio taken from recent income
statements and balance sheets would be used, as this is the approach that ARR uses
(hence its name). This would still be an arbitrary approach though, for why should
past accounting returns on assets be felt to be a useful basis for decisions relating to
the future? In any case, maximisation of accounting rates of return will not, except by
coincidence, promote value maximisation.
It is possible to overcome a major problem of ARR, that is the timing problem,
by using accounting profits that take full account of the finance cost involved with
investment. In practice, however, this can be very unwieldy.
Table 4.1 summarises the relative merits of NPV, IRR, PBP and ARR.