Capital Budgeting

1. SCREENING CAPITAL INVESTMENT PROPOSALS
NON-DISCOUNTED CASH FLOW (UNADJUSTED)
APPROACH

2. ACCOUNTING RATE OF RETURN OR
SIMPLE RATE OF RETURN (ARR)
ARR (also known as book value rate of return) measures
profitability from the conventional accounting standpoint
by relating the required investment to the
future annual net income.
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3. FORMULA:
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4. ILLUSTRATIVE PROBLEM
Consider the following information about a proposed
project:
Initial investment required P65,000.00
Estimated life 20 years
Annual Cash inflows P10,000.00
Salvage value of the asset at the end of 20 years 0
Straight-line method of depreciation will used
REQUIRED:
Compute the ARR a. Initial investment b. Average
Investment
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5. SOLUTION:
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6. DECISION RULE
Under the ARR method, choose the project with the
highest rate of return. Accept the project if the ARR
is greater than the cost capital. Thus:
If: ARR ≥ Required rate of return; Accept
If: ARR ≤ Required rate of return; Reject
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7. ADVANTAGES
1. Easily understood by investor.
2. Used as a rough preliminary screening device of
investment proposals.
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8. DISADVANTAGES
1. Ignores the time value of money.
2. Does not consider the timing component of cash
inflows.
3. Different averaging techniques may yield
inaccurate answers.
4. Concept of capital and income may not be
relevant to the evaluation of investment proposals.
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