Let us make an in-depth study of the merits and demerits of rate of return method.
Merits or Advantages of Rate of Return Method:
Following merits may be taken into consideration:
(1) Rate of return method is very simple and easy to understand.
(2) Its use is easy.
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(3) Rate of return may readily be calculated with the help of accounting data.
(4) The simple rate of return will be fairly close to the true rate of return in investment with extremely long lives. It may be used to measure the current performance of a firm.
(5) It gives due weight-age to the profitability of the project if based on average rate of return. Projects having higher rate of return will be accepted.
(6) It takes into consideration investment and the total earnings from the project during its life time.
Demerits or Disadvantages of Rate of Return Method
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De-merits of rate of return method are as follows:
(1) Rate of return method uses accounting profits and not the cash inflows in appraising the investment projects.
(2) It ignores the time value of money which is an important factor in capital expenditure decisions.
(3) Rate of return method considers only the rate of return and not the length of project lives.
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(4) It ignores the fact that profits can be re-invested and profits can be earned on such investment, which in turn will affect the rate of return.
(5) Rate of return method does not determine the fair rate of return on investment which is left at the discretion of the management. The use of arbitrary rate of return may cause serious distortions in the selection of capital projects.
(6) Rate of return method ignores the benefits which can accrue to the firm from the sale or abandonment of the old equipment or plant.
(7) It considers only the net investment and not the incremental cash outflows, i.e., new investment minus (-) the sale proceeds of the old equipment.
Thus, this method is not much useful, except in evaluating the long-term capital proposals.