Accounting rate of return (ARR)

Definition

Accounting Rate of Return (ARR) is a capital budgeting metric used to evaluate the profitability of an investment. It calculates the return, expressed as a percentage, expected from an investment based on its average annual accounting profit compared to its initial cost.

5 Must Know Facts For Your Next Test

1. ARR is calculated by dividing the average annual accounting profit by the initial investment cost.
2. ARR does not take into account the time value of money, unlike other metrics such as NPV or IRR.
3. The formula for ARR is: ARR = (Average Annual Accounting Profit / Initial Investment Cost) * 100.
4. A higher ARR indicates a more profitable investment relative to its cost.
5. ARR can be influenced by non-cash expenses like depreciation, which affects accounting profit but not cash flow.

Review Questions

• How do you calculate the Accounting Rate of Return?
• Why might ARR be less reliable than other metrics like NPV or IRR when evaluating investment opportunities?
• What impact do non-cash expenses have on the ARR calculation?

Related terms

Net Present Value (NPV):

A capital budgeting method that calculates the present value of future cash flows minus the initial investment.

Internal Rate of Return (IRR):

The discount rate at which the net present value of an investment's future cash flows equals zero.

Payback Period:

The amount of time it takes for an investment to generate cash flows sufficient to recover its initial cost.