Overview
The Accounting Rate of Return (ARR) is a financial metric used to measure the return generated from an investment relative to its initial cost. Unlike discounted cash flow methods, ARR does not consider the time value of money, making it a simple yet limited tool for evaluating investment projects.
Key Components
- Profit Before Interest and Taxation (PBIT): This is the net profit a business generates before deducting interest and taxes.
- Capital Employed: Represents the total capital invested in a business during the period. It can be calculated using either the closing capital at the end of the period or the average capital of the opening and closing balances.
Calculation Formula
The basic formula for ARR is: \[ \text{ARR} = \left( \frac{\text{Average Annual Accounting Profit}}{\text{Average Investment}} \right) \times 100 \]
Examples
Example 1: Basic Calculation
A company with an annual accounting profit of $50,000 and an average investment of $250,000 has an ARR of: \[ \text{ARR} = \left( \frac{50,000}{250,000} \right) \times 100 = 20% \]
Example 2: Using Different Profits
If the company uses profit after interest and taxation totaling $40,000 with the same average investment: \[ \text{ARR} = \left( \frac{40,000}{250,000} \right) \times 100 = 16% \]
Frequently Asked Questions (FAQs)
What is the Accounting Rate of Return (ARR)?
ARR is a straightforward accounting measure used to evaluate the profitability of an investment by comparing the average annual accounting profit to the average investment over a given period.
How is ARR different from Discounted Cash Flow (DCF)?
Unlike DCF methods which consider the time value of money, ARR relies solely on accounting profits and capital employed, thus providing a simpler but less comprehensive measure of profitability.
When should ARR be used?
ARR is most useful in scenarios where a quick, non-complex evaluation of investment profitability is needed and where the time value of money is not a critical consideration.
What are the limitations of ARR?
ARR does not consider the time value of money, tax implications, or varying cash flows, making DCF methods superior for detailed investment appraisals.
Can ARR be negative?
Yes, if the project’s average annual accounting profit is negative, the ARR will also be negative, indicating a loss relative to the invested capital.
Related Terms
Capital Employed
The total capital invested in a business used to generate profits, calculated by adding fixed assets to working capital minus current liabilities.
Discounted Cash Flow (DCF)
A valuation method that uses cash flow projections adjusted for the time value of money to determine the value of an investment.
Internal Rate of Return (IRR)
A DCF-based financial metric that estimates the profitability of potential investments by finding the interest rate that makes the net present value of cash flows equal to zero.
Return on Investment (ROI)
A performance measure used to evaluate the efficiency or profitability of an investment compared to its initial cost.
Online References
- Investopedia - Accounting Rate of Return: Investopedia Setion on ARR
- Corporate Finance Institute (CFI) - ARR: CFI Guide to ARR
- Wikipedia - Accounting Rate of Return: Wikipedia Entry on ARR
Suggested Books for Further Study
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“Financial Management: Theory & Practice” by Eugene F. Brigham and Michael C. Ehrhardt This book provides comprehensive coverage on financial management including investment appraisal techniques.
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“Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen This book explains the principles of corporate finance with detailed sections on investment evaluation criteria.
Accounting Basics: “Accounting Rate of Return (ARR)” Fundamentals Quiz
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