Business – 10.3 Investment appraisal – Payback and ARR | e-Consult

Limitation 1 – Ignores the time value of money

ARR is based on accounting profits, which are recorded in nominal terms and do not discount future cash flows. Consequently, it treats a profit earned in year 1 the same as a profit earned in year 4. This can lead to over‑valuation of long‑term projects and under‑valuation of projects that generate early cash flows, whereas NPV explicitly discounts each cash flow to its present value, providing a more accurate measure of wealth creation.

Limitation 2 – Relies on accounting figures rather than cash flows

ARR uses accounting profit, which can be affected by depreciation methods, accruals, and other non‑cash items. Different accounting policies can therefore change the ARR without any real impact on the project's cash-generating ability. NPV, by contrast, is based on actual cash inflows and outflows, making it less susceptible to manipulation through accounting choices.

Impact on decisions

• Projects with high early cash returns may be rejected by ARR if their average accounting profit is low, even though NPV would show a positive value.
• Projects that use aggressive depreciation to boost accounting profit could appear attractive under ARR, potentially leading to the acceptance of investments that do not enhance cash flow.

Therefore, while ARR is simple to compute, its limitations can cause managers to make sub‑optimal investment choices compared with the more robust NPV approach.