Assessing Accounting Return Approaches

How well do accounting returns measure up to the three criteria that we listed for a good investment decision rule? In terms of maintaining balance between allowing managers to bring into the analysis their judgments about the project and ensuring consistency between analysis, the accounting returns approach falls short. It fails because it is significantly affected by accounting choices. For instance, changing from straight line to accelerated depreciation affects both the earnings and the book value over time, thus altering returns. Unless these decisions are taken out of the hands of individual managers assessing projects, there will be no consistency in the way returns are measured on different projects.

Does investing in projects that earn accounting returns exceeding their hurdle rates lead to an increase in firm value? The value of a firm is the present value of expected cash flows on the firm over its lifetime. Since accounting returns are based upon earnings, rather than cash flows, and ignore the time value of money, investing in projects that earn a return greater than the hurdle rates will not necessarily increase firm value. Conversely, some projects that are rejected because their accounting returns fall short of the hurdle rate may have increased firm value. This problem is compounded by the fact that the returns are based upon the book value of investments, rather than the cash invested in the assets.

Finally, the accounting return works better for projects that have a large up-front investment and generate income over time. For projects that do not require a significant initial investment, the return on capital and equity has less meaning. For instance, a retail firm that leases store space for a new store will not have a significant initial investment, and may have a very high return on capital as a consequence.

Note that all of the limitations of the accounting return measures are visible in the last two illustrations. First, the Disney example does not differentiate between money already spent and money still to be spent; rather, the sunk cost of $ 0.5 billion is shown in the initial investment of $3.5 billion. Second, in both the Bookscape and Aracruz analyses, as the book value of the assets decreases over time, largely as a consequence of depreciation, the operating income rises, leading to an increase in the return on capital. With the Disney analysis, there is one final and very important concern. The return on capital was estimated over 10 years but the project life is likely to be much longer. After all, Disney's existing theme parks in the United States are more than three decades old and generate substantial cashflows for the firm still. Extending the project life will push up the return on capital and may make this project viable.

Notwithstanding these concerns, accounting measures of return endure in investment analysis. While this fact can be partly attributed to the unwillingness of financial managers to abandon familiar measures, it also reflects the simplicity and intuitive appeal of these measures. More importantly, as long as accounting measures of return are used by investors and equity research analysts to assess to overall performance of firms, these same measures of return will be used in project analysis.

capbudg.xls: This spreadsheet allows you to estimate the average return on capital on a project

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