Evaluating accept or reject rule

With the help of the accept reject rule, the financial decision maker can decide whether to accept or reject the investment proposal. According to the Accept Reject rule as an accept reject criterion, the actual accept reject rule would be compare with a predetermined or a minimum required rate of return or cut off rate. A project would qualify to be accepted if the actual accept reject rule is higher than the minimum desired accept reject rule. Otherwise, it is liable to be rejected. Alternatively, the ranking method can be used to select or reject proposals. Thus, the alternative proposals under consideration may be arranged in the descending order of magnitude, starting with the proposal with the highest accept reject rule and ending with the proposal having the lowest accept reject rule. Obviously, projects having higher accept reject rule would be preferred to projects which have lower accept reject rule.

In evaluating accept or reject rule (ARR), as a criterion to select or reject investment projects, its merits and drawbacks need to be considered. The most favorable attributes of the ARR method is its easy calculation. What is required is only the figure of accounting profits after taxes which should be easily obtainable. Moreover, it is simple to understand and use. In contrast to this, the discounted flow techniques involve, as subsequently shown, tedious calculations and are difficult to understand. Finally, the total benefits associated with the project are taken into account while calculating the ARR. Some methods, pay back for instance, do not use the entire stream of incomes.

However this method of evaluating investment proposals suffers from serious deficiencies. The principal shortcoming of the ARR approach arises from the use of accounting income instead of cash flows. In brief, earning calculations ignore the reinvestment potential of a project’s benefits while the cash flows take into account this potential and hence, the total benefits of the project.