Accounting rate of return

This article is about a capital budgeting concept. For other uses, see ARR.

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Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. ^[1] The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment.^[2] Over one-half of large firms calculate ARR when appraising projects. ^[3]

Basic formulas

\text{ARR} = \frac{\text{Average return during period}}{\text{Average investment}}

where:

\text{Average investment} = \frac{\text{Book value at beginning of year 1 + Book value at end of useful life}}{\text{2}}

\mbox{ARR} = {\mbox{Incremental revenue} -\mbox{ Incremental expenses (including depreciation)}\over \mbox{Initial investment}}

\mbox{Average profit} = {\mbox{Profit after tax}\over \mbox{Life of investment}}

Pitfalls

This technique is based on profits rather than cash flow. It ignores cash flow from investment. Therefore, it can be affected by non-cash items such as bad debts and depreciation when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits.
This technique does not adjust for the risk to long term forecasts.
ARR doesn't take into account the time value of money.

References

↑ Accounting Rate of Return - ARR
↑ Chapter 19 Accounting Rate of Return
↑ Arnold, G. (2007). Essentials of corporate financial management. London: Pearson Education, Ltd.

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