Evaluation of ARR

In evaluating the ARR, as a criterion to’ select/reject investment projects, its merits and drawbacks need to be considered, The most favorable attribute of the ARR method is its ea~y calculation. that is required is only the figure of accounting profits after taxes which would he easily obtainable. Moreover, it is simple to understand and use. In contrast to this, the discounted now techniques involve tedious calculations and are difficult to understand. finally the total benefits as calcite with the project arc taken into account while informational( the ARR Some methods. pay back for instance. do not use the entire stream of incomes. However, this method of evaluating investment proposals suffers from serious deficiencies. The principal shortcoming of the ARR approach arise from the use of accounting inn 11 m: instead of cash flow», The Gish now approach i~ markedly superior to accounting earnings for project evaluation. The earnings calculations ignore the investiture pot e initial of a projects h c unfits while till’ cash flow the into .account the potential and. hence, the total benefits of till’ project. The second brindle shortcoming of ARR is that it docs not take into account the time value of Mon The timing of cash inflows and outflows is a major decision variable in financial decision making. Accordingly in the earlier years and later years cannot be valued at par. To the extent the ARR method tracts these benefits at par and fails to take account’ of the differences in till’ time value of Mon •..v, it suffers from a serious deficiency. TI,US, in Example 10.6, the ARR in CISl” of both machines. A and II is te same, although machine B should be preferred since its returns in the early years of its life are greater. Clearly, the, ARR method of evaluating investment’ roosts fails to consider this, Thirdly; the ARR criterion of measuring the worth of investment docs not differentiate between till’ size of the investment required for each project. Competing investment proposals may have the same ARR. but may require different average investments. as shown in Table 10.6. Tile ARR method, in such ;I situation, will leave the firm in :10 indeterminate Position


Finally. this method does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment. The new investment, from the point of view of correct financial decision making should be measured in terms of incremental cash outflows due to new investments that is new investment minus sale proc e eds of the existing equipment :t tax adjustment. But the ARR method docs not make any adjustment in this regard to determine the level of average investments Investments in fixed assets are determined at their acquisition cost. for these reason the ARR leaves much to be desired as a method for project selection.

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