CMA Intermediate · Financial Management and Business Data Analytics · Capital Budgeting
Which statement about the Accounting Rate of Return method is correct?
ARR ignores the time value of money and relies on accounting profits rather than cash flows. Because profits are after depreciation, the method of depreciation affects the result, and rankings can differ from NPV.
- AIt uses cash flows and discounts them at the cost of capital
- BIt ignores the time value of money and uses accounting profitsCorrect
- CIt always gives the same ranking of projects as NPV
- DIt is unaffected by the depreciation method chosen
Explanation
ARR is based on average accounting profit after depreciation, not cash flows, and does not discount. So the depreciation method changes profits and hence ARR. Its ranking can differ from NPV because timing of returns is ignored.
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