The Accounting Rate of Return formula is one of the most widely used techniques for investment appraisals and capital budgeting decisions. The accounting rate of return provides you with the project’s return, which you should compare with the cost of raising capital to finance this project. In terms of reaching a decision, a simple method is to accept any project with an accounting rate of return higher than the cost of capital.
We are going to work through two formulas, using slightly different measures of initial investment and average investment. All is explained below.
Accounting Rate of Return Formula
The accounting rate of return has two different formulas that you can use to derive the project’s return. The first formula is the following:
ARR = Average Annual Profit / Initial Investment
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:
ARR = Average Annual Profit / Average Investment
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 Initial Investment Method
A company is trying to decide whether it 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, you can calculate depreciation as:
Depreciation = (Initial Value – Scrap Value) / Useful Life
or ($100,000-$10,000)/5=$18,000. Therefore, the annual profit is $30,000-$18,000=$12,000. We can therefore calculate the accounting rate of return as (12,000/100,000)%=12%
Example Average Investment Method
When we use the second formula (the average investment method), the annual profit will be the same, but the denominator will be:
Average Investment = (Initial Investment + Scrap value) / 2
or: (100,000 + 10,000)/2=55,000. Therefore, the accounting rate of return will be:
Advantages of Accounting Rate of Return
The advantages of the accounting rate of return are 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 by judgment, accounting policies and non cash items (depreciation), and;
- There are two ways to calculate the accounting rate of return which causes a problem of comparability.
As we mentioned above and in our other finance tutorials, a single measure such as the ARR, APV, IRR or the payback period should not be the sole measure of a project’s acceptance or regection. And even in using these different tools, an overall assessment has to be made as to how the project fits into the firm’s goals and objectives. Some of these softer and longer-term measures can be more difficult to assess. Accountants are famous for saying, there is always safety in numbers.