Book Rate of Return (Advantages and disadvantages)
Financial managers sometimes calculate a book rate of return on a proposed investment. In other words, they look at the prospective book income as a proportion of the book value of the assets that the firm is proposing to acquire. Cash flows and book income are often very different. Thus the accountant labels some cash outflows as capital investments and others as operating expenses. The operating expenses are deducted immediately from each year’s income. The capital expenditures are put on the firm’s balance shit and then depreciated. The annual depreciation charge is deducted from each year’s income. Thus the book rate of return depends on which items the accountant chooses to treat as capital investment and how rapidly they are depreciated:
BOOK RATE ON RETURN 
(3.1)[14]
The company’s book rate of return may not be a good measure of true profitability. It is also an average across all of the firm’s activities. The average profitability of past investments is not usually the right hurdle for new investment. Book return on investment (ROI) is just ratio of after-tax operating income to the net (depreciated) book value assets. Suppose we have to rejected book ROI as a capital investment criterion, and in few companies now use it for that purpose. However, managers frequently asses the performance of division or a plant by comparing its ROI with cost of capital. This is a simple illustration of the different between accounting income and project cash flow: Supermarket chains invest heavily in building and equipping new stores. Manager proposes to invest $1 million. Projected cash flow is:
| YEAR | |||||||
| after 6 | |||||||
| CASH FLOW ($, thousands) |
Table 3.1
Obviously that in real situation it takes two or three years for new store to build up a substantial, habitual clientele. Thus cash flow is low for the first years even in the best location.
On the other hand, manager can see the forecasted book income, ROI.
| YEAR | |||||||
| 1. | Cash flow | ||||||
| 2. | Book value at start of year, Straight-line depreciation | 1.000 | |||||
| 3. | Book value at end of year, Straight-line depreciation | ||||||
| 4. | Book depreciation | ||||||
| 5. | Book income | -67 | +33 | +83 | +131 | +131 | +131 |
| 6. | Book ROI | -.067 | +.04 | +.124 | +.252 | +.393 | +.787 |
Table 3.2
With NPV=0, the true (internal) rate of return of this cash-flow is 10 percent. Table 3.2 shows the store’s forecasted book profitability, assuming straight-line depreciation over its six-year life. The book ROI is lowers than the true return for the first two years and higher afterward (The errors in book ROI always catch up with us in the end. If the firm choose depreciation schedule that overstates a project’s return in some years, it must also understate the return in other years. In fact, manager can understand a project’s IRR as kind of average of the book returns. However, it is not a simple average. The weights are the project’s book values discounted at the IRR). In the end, accounting profitability measures are too low when the project or business is young and are too high as it matures.