This method is designated to consider the relative profitability of different capital investment proposals as the basis for ranking them – the fact neglected by the payout period technique. Since this method uses the accounting rate of return, it is sometimes described as the financial statement method. The rate of return is calculated by dividing earnings by capital invested. The numerator, i.e., earnings can be interpreted in a number of ways. It might mean income after taxes and depreciation, income before taxes and depreciation, or income after taxes but before depreciation. Since both numerator and denominator carry different meanings. It is not surprising if one comes across a number of variations of the average rate of return method.
Decision Rule for Average of Rate of Return Method:
Normally, business firms determine the rate of return. To accept the proposal if ARR > Minimum rate of return (cut off rate) and Reject the project if ARR <Minimum rate of return (cut off rate). In the case of more than one project, where a choice has to be made, the different projects may be ranked in descending or ascending order of their rate of return. The project below the minimum rate will be dropped. In the case of a project yielding a rate of return higher than the minimum rate, it is obvious that a project yielding a higher rate of return will be preferred to all.
Advantages of the Average Rate of Return Method:
(i) Earnings over the entire life of the project are considered.
(ii) This method is easy to understand, simple to follow. The accounting concept of income after taxes is known to every student of accountancy.
Disadvantages of the Average Rate of Return Method:
(i) Like the payback technique, the average return on investment method also ignores the time value of money. Consideration of the distribution of earnings over time is important. It is to be accepted that the current income is more valuable than income received at a later date.
(ii) The method ignores the shrinkage of original investment through the process of charging depreciation allowances against earnings. Even the assumption of regular recovery of capital over time as implied in the average investment approach is not well-founded.
(iii) The average rate of return on the original investment approach cannot be applied to a situation where part of the investment is to be made after the beginning of the project.
(iv) Since ARR can be calculated by using different methods, so results are not the same. Thus, the identification of the right method to compare with the cut of rate is difficult to apply.
(v) Its major limitation is that ARR is based on accounting principles and not on cash flow analysis.
Suitability of using ARR Method:
If the project life is not long, then the method can be used to have a rough assessment of the internal rate of return. The present method is generally used as a supplementary tool only.