The average accounting return
(AAR) is the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. 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: Some measure of average accounting profit
divided by some measure of average accounting value
. The specific definition we will use is: Average net income
divided by Average book value. It is kinds of decision rule to accept or reject the finance project. For decide to these projects value, it needs cutoff rate. This rate is kind of deadline whether this project produces net income or net loss
There are three steps to calculating the AAR.
First, determine the average net income of each year of the project's life. Second, determine the average investment, taking depreciation into account. Third, determine the AAR by dividing the average net income by the average investment. After determine the AAR, compare with
target cutoff rate. For example, if AAR determined is 20%, and given cutoff rate is 25%, then this project should be rejected. Because AAR is lower than cutoff rate so this project will not make sufficient net income to cover initial cost. Average accounting return(AAR) does have advantages and disadvantages. Advantages; It is easy to calculate than other capital budgeting decision rules. It only needs net income data and book values of the investment during its life. Another advantage is needed information will usually be available. Disadvantage; it does not take time value of money
into account. When we average figures that occur at different times, we are treating the near future and the more distant future in the same way. Therefore, there is no clear indication of profitability. And also should use an arbitrary benchmark cutoff rate is kind of disadvantage thing. The last disadvantage is it is based on accounting net income and book values, not cash flows and market values.