Economics Capital Budgeting Questions
The limitations of using the accounting rate of return (ARR) as a capital budgeting technique include:
1. Ignores the time value of money: 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.
2. Ignores cash flows: ARR focuses on accounting profits rather than cash flows. It does not consider the timing and magnitude of cash inflows and outflows, which are crucial for evaluating the profitability of an investment project.
3. Ignores project duration: ARR does not consider the duration of a project. It assumes that the project will continue indefinitely, which may not be the case. This limitation can lead to incorrect investment decisions, especially for projects with different durations.
4. Subjective selection of the required rate of return: ARR requires the selection of a required rate of return, which is subjective and can vary among individuals or organizations. This subjectivity can lead to inconsistent investment decisions.
5. Ignores reinvestment assumption: ARR assumes that the cash flows generated by the project will be reinvested at the same rate of return as the initial investment. However, this assumption may not hold true in reality, leading to inaccurate investment evaluations.
Overall, the limitations of ARR make it less reliable as a capital budgeting technique compared to other methods such as net present value (NPV) or internal rate of return (IRR).