2: UK Financial models used in appraising the most recent ICT project Model (in order of perceived (n = 71) Ranked importance) 1st 2nd 3rd 4th Payback discounted/conventional 62 25 21 15 1 (no company used both) * Internal Rate of Return/ 47 22 14 9 2 Modified Internal Rate of Return * Net Present Value (NPV) 50 18 17 11 4 Internal Rate of Return (IRR) 40 20 12 7 1 Discounted Payback (using 37 14 12 10 1 discounted figures) (DPB) Payback (conventional/ 25 11 9 5 0 non-discounted figures) (PB) Return on investment / 26 6 14 4 2
Accounting rate of return (ROI/ARR) Profitability Index (PI) 12 0 1 6 5 Modified Internal Rate of 7 2 2 2 1 Return (MIRR) Model (in order of perceived Ranking importance) Payback discounted/conventional 2.
As in Table 3, the other tools were not properly used, while the least used technique was the
accounting rate of return (mean = 0.
Why would companies wish to consider the
Accounting Rate of Return rather than the simpler methods of Payback, Net Present Value and Internal Rate of Return?
If a temporary change in investment leads to a temporary change in a reported
accounting rate of return, then the current earnings will be a poor indicator of future earnings and, thus, earnings quality will be low.
The
accounting rate of return is the ratio of the project's average after-tax income to its average book value.
Meanwhile,
accounting rate of return, ROI, and residual income prematurely kill investment ideas in a more subtle fashion.
Similarly, the
accounting rate of return figured less prominently as a capital investment decision making tool.
However, the only justification we can think of for using the
accounting rate of return method is because top management believe that reported profits have an impact on how financial markets evaluate a company.
Pritchett and Wilder (1986), in an extensive study of life-health insurers from 1950 through 1980, used mean-variance and CAPM, as well as
accounting rate of return data.
In a recent paper, Dumenil and Levy [1986] have shown that the economic rate of return and the average
accounting rate of return for the aggregate U.
While focusing significantly on discounted cashflow analysis, such as NPV, this tutorial also examines alternative techniques such as the
accounting rate of return and the payback/discounted payback methodology.
Candidates may also be required to evaluate the same investment using return on capital employed or
accounting rate of return.
