Learning Objective 4 Use and evaluate the accrual accounting rate-of-return (AARR) method
We now consider a fourth method for analyzing the financial aspects of capital budgeting projects. The accrual accounting rate-of-return (AARR) method divides the average annual (accrual accounting) income of a project by a measure of the investment in it. We illustrate this method for Vector using the project’s net initial investment as the amount in the denominator:
If Vector purchases the new hybrid bus, its net initial investment is $648,900. The increase in the expected average annual after-tax operating cash inflows is $174,000. This amount is the expected after-tax total operating cash inflows of $870,000 ($180,000 for 4 years and $150,000 in year 5), divided by the time horizon of 5 years. Suppose that the new bus results in additional depreciation deductions of $120,000 per year ($132,000 in annual depreciation for the new bus, relative to $12,000 per year on the existing bus).* The increase in the expected average annual after-tax income is therefore $54,000 (the difference between the cash flow increase of $174,000 and the depreciation increase of $120,000). The AARR on net initial investment is computed as
The 8.3% figure for AARR indicates the average rate at which a dollar of investment generates after-tax operating income. The new hybrid bus has a low AARR for two reasons: (1) the use of the net initial investment as the denominator and (2) the use of income as the numerator, which necessitates deducting depreciation charges from the annual operating cash flows. To mitigate the first issue, many companies calculate AARR using an average level of investment. This alternative procedure recognizes that the book value of the investment declines over time. In its simplest form, average investment for Vector is calculated as the arithmetic mean of the net initial investment of $648,900 and the net terminal cash flow of $30,000 (terminal disposal value of hybrid bus of $0, plus the terminal recovery of working capital of $30,000):
The AARR on average investment is then calculated as follows:
Companies vary in how they calculate the AARR. There is no uniformly preferred approach. Be sure you understand how the AARR is defined in each individual situation. Projects with AARRs that exceed a specific required rate of return are regarded as acceptable (the higher the AARR, the better the project is considered to be).
The AARR method is similar to the IRR method in that both calculate a rate-of-return percentage. The AARR method calculates the return using operating-income numbers after considering accruals and taxes, whereas the IRR method calculates the return using after-tax cash flows and the time value of money. Because cash flows and time value of money are central to capital budgeting decisions, the IRR method is regarded as better than the AARR method.
AARR computations are easy to understand, and they use numbers reported in the financial statements. The AARR gives managers an idea of how the accounting numbers they will report in the future will be affected if a project is accepted. Unlike the payback method, which ignores cash flows after the payback period, the AARR method considers income earned throughout a project’s expected useful life. Unlike the NPV method, the AARR method uses accrual accounting income numbers, it does not track cash flows, and it ignores the time value of money. Critics of the AARR method argue that these are its drawbacks.
Overall, keep in mind that companies frequently use multiple methods for evaluating capital investment decisions. When different methods lead to different rankings of projects or different decisions regarding individual projects, more weight should be given to the NPV method because the assumptions underlying the NPV method are most consistent with decision making that maximizes a company’s shareholder value.