ACCOUNTING RATE OF RETURN

How is it defined
The amount of profit, or return, that an individual can expect based on an investment made. Accounting rate of return divides the average profit by the initial investment in order to get the ratio or return that can be expected. This allows an investor or business owner to easily compare the profit potential for projects, products and investments. ARR is considered a straight-line method of gathering quantitative information. While this is a positive measure in some aspects, its lack of sophistication is also a drawback. ARR does not consider the time value of money, which means that returns taken in during later years may be worth less than those taken in now, and does not consider cash flows, which can be an integral part of maintaining a business.

How it works/Example:
Also called the "simple rate of return," the accounting rate of return (ARR) allows companies to evaluate the basic viability and profitability of a project based on projected revenue less any moneyinvested. The ARR may be calculated over one or more years of a project's lifespan. If calculated over several years, the averages of investment and revenue are taken. The ARR itself is derived from dividing the average profit (positive or negative) by the average amount of money invested. For instance, if the annual profit for a given project over a three year span averages $100, and the average investment in a given year is $1000, the ARR would be $100 / $1000 = 10%. 1

Why it Matters:
The ARR should be used as a method for quickly calculating a project's viability, particularly where compared to that of other projects. Nevertheless, the ARR's failure to account for accrued interest, taxation, inflation, and cash flows makes it a poor choice for long-range planning. The formula2

Where
1 2

http://www.investinganswers.com/financial-dictionary/stock-valuation/accounting-rate-return-arr-1364 http://en.wikipedia.org/wiki/Accounting_rate_of_return

=Profit/investment equals to ARR.

ARR = Incremental Revenue - Incremental Expenses (Including Depreciation)/Initial Investment Average Profit = Profit After Tax/Life of Project

Decision Rule
Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.

Advantages and Disadvantages

ADVANTAGES
1. Like payback period, this method of investment appraisal is easy to calculate.

DISADVANTAGES
1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial investments. The project which has higher annual income in the latter years of its useful life may rank higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher.

1. It recognizes the profitability factor of 2. It can be calculated in different ways. investment. This is a simple capital Thus there is problem of consistency. budgeting technique and is widely used to provide a guide to how attractive an investment project is.3 3. Another advantage is familiarity. The 3. It uses accounting income rather than

http://accountlearning.blogspot.com/2011/07/advantages-and-disadvantages-of.html

ARR concept is a familiar concept to return on investment (ROI), or return on capital employed.

cash flow information. Thus it is not suitable for projects which having high4 maintenance costs because their viability also depends upon timely cash inflows.

Solved Examples:

Example 1:
An investment of $600,000 is expected to give returns as follows: Year 1 ($50,000), Year 2 ($150,000), Year 3 ($80,000), Year 4 ($20,000).Calculate the average rate of return.5

Solution:
Total returns over the four years = 50,000 + 150,000 + 80,000 + 20,000 = $300,000 Average returns per annum = 300,000 / 4 = $75,000 ARR = 75,000 / 600,000 = 12.5%

Example 2:
Western Ltd has an option of two projects: C and D, with the same initial capital investment of $100,000. The profits for both projects are as follows: Project C: Year 1 ($10,000), Year 2 ($5,000), Year 3 ($15,000) Project D: Year 1 ($12,000), Year 2 ($11,000), Year 3 ($4,000) The estimated resale value of both projects at the end of year 3 is $22,000. Calculate the ARR for

4 5

http://smallbusiness.chron.com/advantages-average-rate-return-method-21482.html http://financelearners.blogspot.in/2011/06/accounting-rate-of-return-arr-examples.html

each

project

and

advise

the

firm.6

Solution:
For Average profit = Average investment Accounting rate For Average profit = Accounting rate Project (10,000 + 5,000 + 15,000) / 3 = (100,000 + 22,000) / 2 of return = 10,000 / 61,000 Project (12,000 + 11,000 + of return = 9,000 C: $10,000 $61,000 16.39% D: $9,000 14.75%

= = =

4,000) / / 61,000

3 =

Since Project C has a higher ARR, it should be chosen.

Example questions:
Question One
Compare the following two mutually exclusive projects on the basis of ARR. Cash flows and salvage values are in thousands of dollars. 7 Project A: Year Cash Outflow Cash Inflow Depriciation Project B: Year 0 1 2 3 0 1 -220 91 130 10 105 2 3

6 7

ibid http://accountingexplained.com/managerial/capital-budgeting/arr

Cash Outflow Cash Inflow Depriciation

-198 87 110 18 84

Question Two
An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.8

ibid