Aar

Average book value $250,000

If the firm has a target AAR less than 20 percent, then this investment is acceptable; otherwise it is not. The average accounting return rule is thus:

Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.

As we will now see, the use of this rule has a number of problems.

You should recognize the chief drawback to the AAR immediately. Above all else, the AAR is not a rate of return in any meaningful economic sense. Instead, it is the ratio

4We could, of course, calculate the average of the six book values directly. In thousands, we would have ($500 + 400 + 300 + 200 + 100 + 0)/6 = $250.

CHAPTER 9 Net Present Value and Other Investment Criteria 287

of two accounting numbers, and it is not comparable to the returns offered, for example, in financial markets.5

One of the reasons the AAR is not a true rate of return is that it ignores time value. When we average figures that occur at different times, we are treating the near future and the more distant future in the same way. There was no discounting involved when we computed the average net income, for example.

The second problem with the AAR is similar to the problem we had with the payback period rule concerning the lack of an objective cutoff period. Because a calculated AAR is really not comparable to a market return, the target AAR must somehow be specified. There is no generally agreed-upon way to do this. One way of doing it is to calculate the AAR for the firm as a whole and use this as a benchmark, but there are lots of other ways as well.

The third, and perhaps worst, flaw in the AAR is that it doesn't even look at the right things. Instead of cash flow and market value, it uses net income and book value. These are both poor substitutes. As a result, an AAR doesn't tell us what the effect on share price will be of taking an investment, so it doesn't tell us what we really want to know.

Does the AAR have any redeeming features? About the only one is that it almost always can be computed. The reason is that accounting information will almost always be available, both for the project under consideration and for the firm as a whole. We hasten to add that once the accounting information is available, we can always convert it to cash flows, so even this is not a particularly important fact. The AAR is summarized in the following table.

Advantages and Disadvantages of the Average Accounting Return

Advantages

Disadvantages

1. Easy to calculate.

2. Needed information will usually be available.

1. Not a true rate of return; time value of money is ignored.

2. Uses an arbitrary benchmark cutoff rate.

3. Based on accounting (book) values, not cash flows and market values.

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