Capital Budgeting Evaluation Techniques 115

Average income after tax

B ************* **
Average investment
Average income after tax but before interest
C:
Initial investment

Average income after tax but before interest

D: - --------------------------------------
Average investment
Average income before income and taxes
E: ---****
Initial investment

Average income before income and taxes

F: -=-.
Average investment
Total income after tax but before depreciation - Initial investment Initial investment
G: ------------------------------------------------------------------------------- X Yrs.
2

This method is superior to the payback period, but is fundamentally unsound. While it
does take account of the earnings over the entire economic Ilife of a project, it fails to
take account of the time value of money. This weakness is made worse by the failure
to specify adequately the relative attractiveness of alternative proposals. It is biased
against short term projects in the same way that payback is biased against longer term
Ones.

Evaluation

Traditionally as a popular investment appraisal criterion, the accounting rate of return

has the following virtues
It is simple to calculate.

It is based on accounting information which is readily available and familiar to

businessmen.

It considers benefits over the entire life of the project.

Since it is based on accounting measures, which can be readily obtained from the
financial accounting system of the firm, it facilitates post-auditing of capital
expenditures.
While income data for the entire life of the project is normally required for
calculating the accounting rate of return one can make do even if complete
income date is not available. For example, when due to indeterminacy of project
life a complete forecast of income cannot be obtained, the accounting rate of
return can be calculated on the basis of income for some typical year or income
for the first three to five years.