Accounting rate of return
Another variation of ARR formula uses initial investment instead of average investment. Calculate its accounting rate of return assuming that there are no other expenses on the project.
ARR is used in investment appraisal. Also, ARR does not take into account the impact of cash flow timing. Related Courses.
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.
Possible replacement measurements are net present valuethe internal rate of returnand constraint analysis. Similar Terms The accounting rate of return is also known as the average rate of return or the simple rate of return.
Compare Investment Accounts. Constraint analysis. The ARR calculation would not factor in the lack of cash flow in the first three years.
Average rate of return questions
But accounting rate of return ARR method uses expected net operating income to be generated by the investment proposal rather than focusing on cash flows to evaluate an investment proposal. It recognizes the profitability factor of investment. The result of the calculation is expressed as a percentage. The measure does not factor in whether or not the capital project under consideration has any impact on the throughput of a company's operations. This measure would be of the most use for reviewing short-term investments where the impact of the time value of money is reduced. 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. It factors in any possible annual expenses or depreciation expense that's associated with the project. ARR can be used when deciding on an investment or an acquisition. Use the straight line depreciation method. Compare Investment Accounts. The measure is not adequate for comparing one project to another, since there are many other factors than the rate of return that should be considered, not all of which can be expressed quantitatively. Suppose, if we use ARR to compare two projects having equal initial investments. The measure does not factor in the time value of money.
Thus, if there is currently a high market interest ratethe time value of money could completely offset any profit reported by a project - but the accounting rate of return does incorporate this factor, so it clearly overstates the profitability of proposed projects.
Disadvantages It ignores time value of money. In the ARR calculation, depreciation expense and any annual costs must be subtracted from annual revenue to yield the net annual profit.
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