Simple Rate of Return Method

Simple Rate of Return Method:

Learning Objectives:

Compute the simple rate of return for an investment project.

Definition and Explanation:

The simple rate of return method is another capital budgeting technique that does not involve discounted cash flows. The method is also known as the accounting rate of return, the unadjusted rate of return, and the financial statement method. Unlike the other capital budgeting methods that we have discussed, the simple rate of return method does not focus on cash flows. Rather, it focuses on accounting net operating income. The approach is to estimate the revenue that will be generated by a proposed investment and then to deduct from these revenues all of the projected expenses associated with the project. The net operating incomes then related to the initial investment in the project, as shown in the following formula:

Formula / Equation:

[Simple rate of return = (Incremental revenues − Incremental expenses, including depreciation
= Incremental net operating income) / Initial investment*]

*The investment should be reduced by any salvage from the sale of old equipment.

Or, if a cost reduction project is involved, formula / Equation becomes:

[Simple rate of return = (Cost savings − Depreciation on new equipment) / Initial investment*]

*The investment should be reduced by any salvage from the sale of old equipment.

Examples:

Example 1:

Brigham Tea, Inc., is a processor of low acid tea. The company is contemplating purchasing equipment for an additional processing line. The additional processing line would increase revenues by $9,000 per year. Incremental cash operating expense would be $40,000 per year. The equipment would cost $180,000 and have a nine year life. No salvage value is projected.

Simple rate of return = ($90,000 Incremental revenues) − ($40,000 Cash operating expenses + $20,000 Depreciation) / $180,000 Initial investment

= $30,000 / $180,000
= 16.7%

Example 2:

Midwest Farms, Inc., hires people on a part-time basis to sort eggs. The cost of this hand sorting process is $30,000 per year. The company is investigating the purchase of an egg sorting machine that would cost $90,000 and have a 15-years useful life. The machine would have negligible salvage value, and would cost $10,000 per year to operate and maintain. The egg sorting equipment currently being used could be sold now for a scrap value of $2,500.

A cost reduction project is involved in this situation. By applying the above formula, we can compute the simple rate of return as follows:

Simple rate of return = ($20,000* Cost savings − $6,000** Depreciation of new equipment) / $90,000 − $2,500

= 16.0%

*$30,000 − $10,000 = $20,000 cost savings.
**$90,000 / 15 years = $6,000 depreciation.

Criticisms/Limitations of the Simple Rate of Return:

The most damaging criticism of the simple rate of return method is that it does not consider the time value of money. The simple rate of return method considers a dollar received 10 years from now as just as valuable as a dollar received today. Thus, the simple rate of return method can be misleading if the alternatives being considered have different cash flow patterns. Additionally, many projects do not have constant incremental revenues and expenses over their useful lives. As a result the simple rate of return will fluctuate from year to year, with the possibility that a project may appear to be desirable in some years and undesirable in other years. In contrast, the net present value method provides a single number that summarized all of the cash flows over the entire useful life of the project.

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