The Accounting Rate of Return method is one of the most widely used techniques for investment appraisals and capital budgetingÂ decisions. The accounting rate of return provides you with the return of the project which should be compared with the cost of raising capital to finance this project. In terms of reaching a decision, a simple method is to accept any project that has an accounting rate of return that is higher than the cost of capital.

## Accounting Rate of Return formula

The accounting rate of return has two different formulas that can be used to derive the return of the project. The first formula is the following:

expressed as a percentage and where:

- Average Annual Profit is the annual cash inflow that the project will generate after deducting depreciation.
- Initial Investment is the capital expenditure that is required to undertake the project.

For the second formula, the initial investment will need to be replaced by the average investment. Therefore, the accounting rate of return becomes:

expressed as a percentage and where:

- Average Investment is the capital expenditure that is required to undertake the project plus the final scrap value of the machinery divided by two.

## Accounting Rate of Return example

Example: A company is trying to decide whether is should accept a project with the following details:

- The initial capital expenditure requirements are $100,000 for a machine that will have a five years useful life.
- Depreciation is calculated on a straight line basis.
- The scrap value of the machine is $10,000
- The project is expected to have $30,000 profit

Using the first way to calculate the accounting rate of return, depreciation can be calculated as:

or ($100,000-$10,000)/5=$18,000. Therefore, the annual profit is $30,000-$18,000=$12,000. The accounting rate of return can be therefore calculated as (12,000/100,000)%=12%

Using the second formula (the average investment method), the annual profit will be the same but the denominator will be:

or: (100,000 + 10,000)/2=55,000. Therefore, the accounting rate of return will be:

12,000/55,000=21.8%.

## Advantages of accounting rate of return

The advantages of the accounting rate of return as follows:

- ARR offers a straightforward way to calculate the required return of the project.
- It offers a certain degree of comparability between projects.

## Disadvantages of accounting rate of return

The disadvantages of the accounting rate of return are as follows:

- It does not take into account the time value of money or in other words it does not recognize that $1 now will not have the same buying power tomorrow
- It can not (or should not) be used as the only way to appraise a project. The net present value should be also calculated as calculating only the return of a project can give a distorted image when projects that have significantly different capital expenditure are compared.
- It uses accounting figures which can be affected byÂ judgment, accounting policies and non cash items (depreciation).
- There are two ways to calculate the accounting rate of return which causes a problem of comparability.

I found your teaching very useful for my work on project appraisal.

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Why would a method that can deliver two very different answers be in use still?. While i agree with its simplicity, and the cautionary that it must be used with other methods, I wonder why there are two calculation formulae/methods that will result in different answers.

Thanks so much for the lesson

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