First, determine the average net income of each year of the project's life. Second, determine the average investment, taking depreciation into account. Third, determine the AAR by dividing the average net income by the average investment. After determine the AAR, compare with target cutoff rate. For example, if AAR determined is 20%, and given cutoff rate is 25%, then this project should be rejected. Because AAR is lower than cutoff rate so this project will not make sufficient net income to cover initial cost. Average accounting return(AAR) does have advantages and disadvantages. Advantages; It is easier to calculate than other capital budgeting decision rules. It only needs net income data and book values of the investment during its life. Another advantage is needed information will usually be available. Disadvantage; it does not take time value of money into account. When we average figures that occur at different times, we are treating the near future and the more distant future in the same way. Therefore, there is no clear indication of profitability. Also the use of an arbitrary benchmark cutoff rate is a disadvantage. The last disadvantage is it is based on accounting net income and book values, not cash flows and market values.
