Accounting Rate of Return (ARR)

The Accounting Rate of Return is a simple rate used to evaluate the potential profitability of an investment. It examines the average annual accounting profit relative to the initial investment.

Understanding the Accounting Rate of Return (ARR)

When considering sizable business investment opportunities, ARR provides a quick glance at how much return one can expect. Unlike some investment evaluation tools that focus on cash flow, the ARR focuses on annual accounting profit versus the average capital cost.

The Formula for ARR

The ARR formula is:

ARR = Average Annual Profit / Average Investment Cost x 100%

Here, the average annual profit excludes operating expenses but includes annual revenues minus annual expenses. The average investment cost considers the initial outlay and the annual investment cost spread overtime periods.

How to Calculate ARR

1. Determine the annual accounting profit by subtracting annual costs from annual revenues.
   2. Calculate the average investment cost by considering both the initial cost and depreciation expense.
   3. Use the simple formula mentioned above.

Example of the ARR

Let’s say a company plans a capital investment of $100,000 in costly equipment purchases. They expect an annual profit of $20,000 after operating income and charges for depreciation. Using the ARR formula:

ARR = $20,000 / $100,000 x 100% = 20% 

Advantages & Disadvantages Of Accounting Rate Of Return:

Advantages:

1. A percentage return provides straightforward insight.
   – When it comes to making quick financial decisions, having results in a percentage format is advantageous. A percentage return offers a clear, easy-to-understand snapshot of the potential profitability of an investment. Whether it’s a 10% or 50% return, stakeholders can quickly gauge the attractiveness of an opportunity.
2. Helps compare individual projects easily.
   – If a company has multiple potential investments or projects on the table, the ARR serves as a uniform metric to compare them side-by-side. This makes prioritization and decision-making more streamlined. For instance, a project with an ARR of 15% would generally be more appealing than one with an ARR of 8%, all else being equal.
3. Uses non-discounted cash flow formula, simplifying calculations.
   – Some investment evaluation tools require complex calculations that consider discounted cash flows, which factor in the time value of money. The ARR sidesteps this complexity by focusing on simple annual profits and average investment costs. This makes it easier for businesses to compute without needing advanced financial tools or expertise.

Disadvantages:

1. Doesn’t consider the time value of money.
   – Money’s value tends to decrease over time due to factors like inflation. A dollar received today is worth more than a dollar received five years down the line. By ignoring this principle, the ARR can sometimes provide an overly optimistic view of an investment, especially for long-term projects.
2. Overlooks future cash flows beyond simple annual profits.
   – While ARR emphasizes the average annual accounting profit, it does not account for varying cash inflows and outflows that might occur throughout the life of an investment. For instance, an investment might have higher cash inflows in its earlier years and lesser in the later years, which won’t be adequately captured by the ARR.
3. May not account for changes in annual rate or annual percentage rate over time.
   – Economic conditions, interest rates, and market dynamics can cause fluctuations in the annual rate or annual percentage rate. If these rates change substantially over the life of an investment, the actual return can differ from the ARR’s prediction. This lack of adaptability can lead to miscalculated investment decisions.

Accounting Rate of Return vs. Required Rate of Return

While ARR gives an average rate of return over the investment’s life, the required rate of return (or hurdle rate) is the minimum rate a company expects. The latter considers more factors like risk, while ARR focuses on the initial book and residual book values.

Frequently Asked Questions:

How Does Depreciation Affect the Accounting Rate of Return?

-Depreciation reduces the asset investment value, affecting both profits after depreciation and the average book value used in ARR calculations.

What Are the Decision Rules for the Accounting Rate of Return?

-If ARR exceeds the hurdle rate or a set percentage rate, the investment is typically considered. If lower, it may be passed over.

What Is the Difference Between ARR and IRR?

-While ARR uses annual accounting profit and average capital cost, IRR (internal rate) focuses on cash inflows and the initial cash outlay. IRR also considers the time value of money, making it different from the simple ARR approach.