annual rate of return
Accounting rate of return
Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.
Formula
Accounting Rate of Return is calculated using the following formula:
ARR =
Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.
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.
Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. 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.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:
Year 0 1 2 3
Cash Outflow -220
Cash Inflow 91 130 105
Salvage Value 10
Project B:
Year 0 1 2 3
Cash Outflow -198
Cash Inflow
Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.
Formula
Accounting Rate of Return is calculated using the following formula:
ARR =
Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.
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.
Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. 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.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:
Year 0 1 2 3
Cash Outflow -220
Cash Inflow 91 130 105
Salvage Value 10
Project B:
Year 0 1 2 3
Cash Outflow -198
Cash Inflow