Accounting Rate of Return (ARR)

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ARR is the average annual net income (incremental income, ie., the average annual profit after tax) of the project as a percentage of the investment. It is also preferred to take average investment instead of investment.

$ARR=\frac{Average\ annual\ net\ income\ (Average\ annual\ profit\ after\ tax)}{Investment\ (or\ Average\ Investment)}\times100\ %$

In numerator, average annual net income is the average of net income for the whole life of the project. It is calculated by adding up the profit after tax for each year and dividing the result by the number of years.

In denominator, if you take investment, it is the investment of the project. If you take average investment of the project, then it can be calculated as

$Salvage\ Value+\frac{1}{2}(Investment\ -\ Slavage\ Value)$

Numerical Problem

Consider a project requires an investment of Rs. 100000. The profit after tax and depreciation are estimated to be as follows: Year 1 – Rs. 10000, Year 2 – Rs. 15000, Year 3 – Rs. 20000, Year 4 – 25000, and Year 5 – 20000. It is also estimated that the scrap value of the investment at the end of 5^th year is Rs. 10000. Calculate ARR.

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Decision Rule:

If the ARR is higher than the minimum rate (cut off rate) established by the management, accept the project.

If the ARR is less than the minimum rate (cut off rate) established by the management, reject the project.

This method can also be useful in selecting a project from a number of projects. This can be done by ranking the projects based on ARR. First rank is given to the project with highest ARR and lowest rank to project with lowest ARR. Accept the project with higher ARR.

Advantages

1. It is simple and easy to calculate

2. It uses accounting information which is readily available data prepared for routine financial reports. So, no need of any specific procedures to generate data.

3. Accounting information data are used to evaluate performance of management. So, using the same data in decision making and performance evaluation ensures consistency.

4. It considers benefits over entire life of the project. And also provides a measure of profitability of the project.

Disadvantages

1. It ignores the time value of money.

2. ARR is based on accounting profit. So, it depends on the choice of accounting procedures.

3. It only includes book value of the investment.

4. ARR uses net income rather than cash flow. Net income is a useful measure of profitability but cash flow is considered as a better measure of investment’s performance.

Accounting Rate of Return (ARR)