Q3SE - Horngren'S Financial And Managerial Accounting

Question

Using accounting rate of return to make capital investment decisions

Carter Company is considering three investment opportunities with the following accounting rates of return:

	Project X	Project Y	Project Z
ARR	13.25%	6.58%	10.47%

 

Use the decision rule for ARR to rank the projects from most desirable to least desirable. Carter Company’s required rate of return is 8%.

Step-by-Step Solution

Answer

Rank	Project
1	X
2	Z
3	Y

Step 1: Definition of Accounting Rate of Return

The return percentage calculated under capital budgeting using the net income generated and the initial investment made is known as the accounting rate of return. It does not take into consideration the time value of money. 

Step 2: Ranking of projects

1. Project X is given 1^st rank because it represents the highest accounting rate of return and is, therefore, the most desirable.
2. Project Z is given 2^nd rank because it represents an accounting rate of return lower than project X but higher than project Y. 
3. Project Y is the least desirable because this project's accounting rate of return is lower than the required rate of return.