Chapter 12, Problem 1DQ

What are the principal objections to the use of the average rate of return method in evaluating capital investment proposals?

To determine

State the principal objection to use the average rate of return method.

Explanation of Solution

Average Rate of Return:

Average rate of return is a method that measures the average earnings of a particular business, as a percentage of the average investment. It is also known as accounting rate of return.

Calculation of Average rate of return:

$\text{Average}\text{Rate}\text{of}\text{Return}\}\text{=}\frac{\left(\text{Estimated}\text{Average}\text{Annual}\text{Income}\right)}{\left(\text{Average}\text{Investment}\right)}\text{}\times 100$

The major objection for using the average rate of return method is as follows:

1. Average rate of return method doesn’t consider the expected cash flows from the investment proposals.

2. It also doesn’t consider the period (timing) of the expected cash flows.