What are the limitations of using the accounting rate of return (ARR) as a capital budgeting technique?

The accounting rate of return (ARR) is a capital budgeting technique that measures the profitability of an investment by comparing the average annual accounting profit to the initial investment cost. While the ARR has its advantages, it also has several limitations that need to be considered. These limitations include:

1. Ignores the time value of money: The ARR does not consider the time value of money, which means it does not account for the fact that money received in the future is worth less than money received today. This limitation can lead to inaccurate investment decisions, as it fails to consider the opportunity cost of tying up capital in a project.

2. Ignores cash flows: The ARR focuses solely on accounting profits and ignores the timing and magnitude of cash flows. Cash flows are crucial in capital budgeting decisions as they represent the actual inflows and outflows of cash. By disregarding cash flows, the ARR fails to provide a comprehensive picture of the investment's profitability.

3. Relies on accounting measures: The ARR relies heavily on accounting measures, such as net income or operating profit, which are subject to various accounting policies and practices. These measures can be manipulated or distorted, leading to inaccurate ARR calculations. Additionally, accounting measures do not always reflect the economic reality of a project, making the ARR less reliable.

4. Ignores project duration: The ARR does not consider the duration of a project. It assumes that the project will generate the same annual profit throughout its lifespan, which is often not the case. Projects may have different cash flows in different years, and the ARR fails to account for this variability.

5. Does not consider risk: The ARR does not incorporate the element of risk associated with an investment. It does not consider the uncertainty or variability of future cash flows, which is crucial in making investment decisions. By ignoring risk, the ARR may lead to the selection of projects with lower returns but lower risk, or vice versa.

6. Ignores reinvestment opportunities: The ARR does not consider the reinvestment opportunities available to the firm. It assumes that all profits are reinvested at the same rate as the initial investment, which may not be realistic. This limitation can lead to incorrect investment decisions, as it fails to account for the potential for higher returns from alternative investment opportunities.

In conclusion, while the accounting rate of return (ARR) is a simple and easy-to-understand capital budgeting technique, it has several limitations that need to be considered. Its failure to account for the time value of money, cash flows, project duration, risk, and reinvestment opportunities can lead to inaccurate investment decisions. Therefore, it is important to use the ARR in conjunction with other capital budgeting techniques to make more informed investment decisions.