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BOOK RATE OF RETURN

We pointed out that net present value and internal rate of return are both discounted cash-flow measures. In other words, each measure depends only on the project s cash flows and the opportunity cost of capital. But when companies report to shareholders on their performance, they do not show simply the cash flows. Instead they report the firm s book income and book assets.

Shareholders and financial managers sometimes use these accounting numbers to calculate a book rate of return (also called the accounting rate of return). In other words, they look at the company s book income (i.e., accounting profits) as a proportion of the book value of the assets:

Book rate of return = book income book assets

Book Rate of Return

Salad Daze invests $90,000 in a vegetable washing machine. The machine will increase cash flows by $50,000 a year for 3 years, when it will need to be replaced. The contribution to accounting profits equals this cash flow less an allowance for depreciation of $30,000 a year. (We ignore taxes to keep things simple.) The book return on this project in each year can be calculated as follows:

as operating expenses. The operating expenses are deducted immediately from each year s income, while the capital investment is depreciated over a number of years. Thus the book rate of return depends on which items the accountant chooses to treat as capital investments and how rapidly they are depreciated. Book rate of return is not generally the same as the internal rate of return and, as you can see in Self-Test 6.4, the difference between the two can be considerable. Book rate of return therefore can easily give a misleading impression of the attractiveness of a project.

Managers seldom make investment decisions nowadays on the basis of accounting numbers. But they know that the company s shareholders pay considerable attention to book measures of profitability and naturally, therefore, they look at how major projects would affect the company s book rate of return.

Investment Criteria

When Projects Interact

Let s pause for a moment to review. We have seen that the NPV rule is the most reliable criterion for project evaluation. NPV is reliable because it measures the difference between the cost of a project and the value of the project. That difference the net present value is the amount by which the project would increase the value of the firm. Other rules such as payback period or book return may be viewed at best as rough proxies for the attractiveness of a proposed project; because they are not based on value, they can easily lead to incorrect investment decisions. Of the alternatives to the NPV rule, IRR is clearly the best choice in that it usually results in the same accept-or-reject decision as the NPV rule, but like the alternatives, it does not quantify the contribution to firm value. We will see shortly this can cause problems when managers have to choose among competing projects.

We are now ready to extend our discussion of investment criteria to encompass some of the issues encountered when managers must choose among projects that interact that is, when acceptance of one project affects another one. The NPV rule can be adapted to these new problems with only a bit of extra effort. But unless you are careful, the IRR rule may lead you astray.

MUTUALLY EXCLUSIVE PROJECTS

Most of the projects we have considered so far involve take-it-or-leave-it decisions. But almost all real-world decisions about capital expenditures involve either or choices.

You could build an apartment block on that vacant site rather than build an office block. You could build a 5-story office block or a 50-story one. You could heat it with oil or with natural gas. You could build it today, or wait a year to start construction. Such choices are said to be mutually exclusive.

When you need to choose between mutually exclusive projects, the decision rule is simple. Calculate the NPV of each project and, from those options that have a positive NPV, choose the one whose NPV is highest.

BOOK RATE OF RETURN Accounting income divided by book value. Also called accounting rate of return.

MUTUALLY EXCLUSIVE PROJECTS Two or more projects that cannot be pursued simultaneously.