Accounting rate of return

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 formulae

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

where

• $\text{Average investment} = \frac{\text{Book value at beginning of year 1 + Book value at end of useful life}}{\text{2}}$=Profit/investment equals to ARR.

ARR = Incremental Revenue - Incremental Expenses (Including Depreciation)/Initial Investment

Average Profit = Profit After Tax/Life of Project

References

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