116 Financial Management
The shortcomings of the accounting rate of return criterion seem to be considerable:
l It is based upon accounting profit, not cash flow.
l It does not take into account the time value of money. To illustrate this point,
consider two investment proposals X and Y, each requiring an outlay of Rs
1,00,000. Both the proposals have an expected life of four years after which
their value would be nil. Relevant details of these proposals are given below:PROPOSAL X
Year Book Value Depreciation Profit Cash
after tax
0 1,00,000 0 0 1,00,000
1 75,000 25,000 40,000 65,000
2 52,000 25,000 30,000 55,000
3 50,000 25,000 20,000 45,000
4 0 25,000 10,000 35,000
PROPOSAL Y
Year Book Value Depreciation Profit Cash
after tax
0 (1,00,000) 0 0 (1,00,000)
1 70,000 25,000 10,000 35,000
2 50,000 25,000 20,000 45,000
3 25,000 25,000 30,000 55,000
4 0 25,000 40,000 65,000Both the proposals, with an accounting rate of return (measure A) of 50% look alike
from the accounting rate of return point of view, though project X, because it provides
benefits earlier, is much more desirable. While the payback period criterion gives no
weight to more distant benefits, the accounting rate of return criteria seems to give
them too much weight.
l There are, as we have seen, numerous measures of accounting rate of return.
This can create controversy, confusion and more confusion, and problems in
interpretation.
l Accounting income (whatever particular measure of income we choose) is not
uniquely defined because it is influenced by the methods of depreciation, inventory
valuation, and allocation of certain costs. Working with the same basic accounting
data, different accountants are likely to produce different income figures. A
similar problem, though less severe, exists with respect to investment.
l The argument that the accounting rate of return measure facilitates post-auditing
of capital expenditure is not very valid. The financial accounting system of a firm