Using ARR will enable the investors to decide on viability and profitability of capital projects to be undertaken. It also helps investors analyse the risk involved in the investments and conclude if the investment would yield enough earnings to cover the risk level. It is one of the widely used financial ratios and comes handy during the decision-making process when different projects have to be compared and selected. However, ARR calculation does not consider the interest accrued, taxes, inflation, etc., this makes it an insufficient method for huge and long-term capital investments.
How to calculate the accounting rate of return (ARR)?
- Average accounting profit is the arithmetic mean of the expected profit earned or to be earned over the life of the project.
- The average investment is the sum of the beginning and ending book value of the project divided by two. In certain cases, the initial value of the investment will also be considered instead of average value.
If the result is equal to or greater than the desired ARR, then the project is accepted. When two or more projects are compared, the project that has greater ARR is accepted.
Generally, ARR calculation is not only done before accepting the proposal, but it is also done year-on-year to check on the returns from the project since ARR does not consider multi-period variables for its calculation.
What are the advantages and disadvantages of using the accounting rate of return?
|1||This is a simple method which uses the profit from an investment to quickly know the return.||This method is based on accounting profits only and does not consider the cash inflows, taxes, etc.|
|2||It is easy to calculate and understand the payback pattern over the economic life of the project||This method cannot be used where the investment in a project is made at different times or in parts.|
|3||It shows the profitability of an investment and helps to measure the current performance of the project||One of the main disadvantages of this method is that it ignores the time factor. Time value of money is an important factor in deciding the viability of investment|
|4||This method enables the comparison of various projects of competitive nature||When different projects are compared, this method does not consider the life period of various investments and hence it may not produce the accurate results as required.|
|5||Small-time investors would be using this method more frequently for appraising their investment decision||This method ignores the external factors and also the results are different if the same project is analyzed using return on investment method. Hence it is not suitable for huge and long-term projects|
- If the annual profit for a project over the life of the investment averages to Rs. 20,000, and the average investment value in a given year is Rs. 100,000, then ARR would be calculated as below:
20000 / 100000 = 20% is the ARR
- There are two different projects a company is considering for investment and a decision has to be made based on which project yields better ARR. Following are the details:
|Description||Proposal I||Proposal II|
|Estimated average annual profit from the projects (A)||RS. 40,000||Rs. 30,000|
|Average Investment Value (B)||Rs. 140,000||Rs. 100,000|
|Estimated ARR (A/B)||29%||30%|
When a decision has to be made only based on the accounting rate of return:
The proposal II has 30% ARR and yields a better result to the company. Hence Proposal II should be selected.