Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 9. Net Present Value and

Other Investment Criteria

© The McGraw−Hill^315

Companies, 2002

THE AVERAGE ACCOUNTING RETURN

Another attractive, but flawed, approach to making capital budgeting decisions involves
the average accounting return (AAR). There are many different definitions of the
AAR. However, in one form or another, the AAR is always defined as:

The specific definition we will use is:

To see how we might calculate this number, suppose we are deciding whether or not to
open a store in a new shopping mall. The required investment in improvements is
$500,000. The store would have a five-year life because everything reverts to the mall

Average net income

Average book value

Some measure of average accounting profit

Some measure of average accounting value

CONCEPT QUESTIONS

9.3a In words, what is the discounted payback period? Why do we say it is, in a

sense, a financial or economic break-even measure?

9.3bWhat advantage(s) does the discounted payback have over the ordinary

payback?

CHAPTER 9 Net Present Value and Other Investment Criteria 285

Advantages and Disadvantages of the Discounted Payback Period Rule

Advantages Disadvantages

1. Includes time value of money.


2. Easy to understand.


3. Does not accept negative estimated
   NPV investments.


4. Biased towards liquidity.
   
   
   1. May reject positive NPV investments.
   
   
   2. Requires an arbitrary cutoff point.
   
   
   3. Ignores cash flows beyond the cutoff
      date.
   
   
   4. Biased against long-term projects, such
      as research and development, and new
      projects.
   
   
   
   

Calculating Discounted Payback

Consider an investment that costs $400 and pays $100 per year forever. We use a 20 percent

discount rate on this type of investment. What is the ordinary payback? What is the discounted

payback? What is the NPV?

The NPV and ordinary payback are easy to calculate in this case because the investment

is a perpetuity. The present value of the cash flows is $100/.2 $500, so the NPV is $500 


400 $100. The ordinary payback is obviously four years.

To get the discounted payback, we need to find the number of years such that a $100 an-

nuity has a present value of $400 at 20 percent. In other words, the present value annuity fac-

tor is $400/100 4, and the interest rate is 20 percent per period; so what’s the number of

periods? If we solve for the number of periods, we find that the answer is a little less than nine

years, so this is the discounted payback.

EXAMPLE 9.3

9.4

average accounting

return (AAR)

An investment’s average

net income divided by its

average book value.