Average Accounting Return

Another flawed technique (which is frequently used)

how it works

take the average project earnings after taxes and depreciation, and divide it by the average book value of the investment during its life (considering depreciation).

= avg Net Income / avg amount invested

1. determine average net income

N.I. = cash flow - depreciation - taxes

note, however that depreciation is not a cash flow, but is instead an accounting charge showing the loss in value of the store over time.

Figure out the N.I. in each year, add them up, and divide...to get the average N.I.

2. determine the average investment

This one is not as obvious as it seems.

If you have an investment of $300,000, the the project will last 3 years...you would think that the average investment is $100,000....wrong! You have to remember that the initial investment comes at t=0, and that income statements come out at the end of each year, t=1,2,3. So the value of the investment at t=0 is $300,000 and with straight line depreciation the value at t=1 is 200,000, at t=2 is 100,000, and at t=3 is 0....so 300+200+100+0 / 4....yes, thats = 600,000/4 = 150,000 (not the 100,000 that you estimated :-)

Popularity

easy to calculate using accounting numbers that are readily available to public. (from accounting system)... so media and public analysts use this method alot.

The problem is that many managers then also use this technique to meet expectations of media...but might make bad decisions (NPV).

Flaws

1. the inputs come from accounting numbers, which may or may not reflect reality. They are subject to accountants judgment and do not reflect real cash flows.

2. Misses the timing of cash flows. this system does not differentiate between N.I. in the final year vs. NI it the first year (unlike net present value methods which are better)

3. There is an arbitrary cut off value for accepting and rejecting projects. Unlike the NPV analysis, where the discount rate can be tied to the market, its difficult to correlate the accounting rate of return to market discount rates.