Accounting Rate of Return

Definition

The accounting rate of return (ARR) is a non-time value-based method used to evaluate the profitability and financial performance of a capital investment project. It measures the average annual net income generated by an investment as a percentage of the initial investment cost.

5 Must Know Facts For Your Next Test

1. The accounting rate of return is a simple and straightforward method for evaluating the profitability of a capital investment project.
2. ARR is calculated by dividing the average annual net income generated by the investment by the initial investment cost.
3. Unlike time value-based methods, such as net present value (NPV) and internal rate of return (IRR), ARR does not consider the time value of money.
4. ARR is often used as a complementary metric to time value-based methods, providing a different perspective on the investment's financial performance.
5. The main advantage of ARR is its simplicity, making it a useful tool for quick evaluations and comparisons of investment alternatives.

Review Questions

• Explain how the accounting rate of return (ARR) is calculated and what it measures.
  • The accounting rate of return (ARR) is calculated by dividing the average annual net income generated by an investment by the initial investment cost. This metric measures the average annual profitability of the investment as a percentage of the initial capital outlay. For example, if an investment has an average annual net income of $50,000 and an initial cost of $500,000, the ARR would be 10% ($50,000 / $500,000).
• Compare and contrast the accounting rate of return (ARR) with time value-based methods, such as net present value (NPV) and internal rate of return (IRR), in capital investment decisions.
  • The key difference between ARR and time value-based methods like NPV and IRR is that ARR does not consider the time value of money. ARR simply looks at the average annual net income generated by an investment relative to the initial cost, while NPV and IRR take into account the timing of cash flows and the opportunity cost of capital. This means that ARR may not provide a complete picture of an investment's long-term profitability, as it does not account for the time value of money. However, ARR can still be a useful complementary metric, as it offers a straightforward and easy-to-understand assessment of an investment's financial performance.
• Evaluate the advantages and limitations of using the accounting rate of return (ARR) in capital investment decisions, particularly in the context of non-time value-based methods.
  • The primary advantage of the accounting rate of return (ARR) is its simplicity, making it a quick and easy-to-understand metric for evaluating the profitability of a capital investment project. ARR does not require complex calculations or considerations of the time value of money, which can be beneficial for quick comparisons of investment alternatives. However, the main limitation of ARR is that it does not account for the time value of money, which can lead to a less comprehensive assessment of an investment's long-term financial performance. This means that ARR may not accurately capture the true economic value of an investment, as it does not consider the opportunity cost of capital or the timing of cash flows. As a result, ARR is often used in conjunction with time value-based methods, such as NPV and IRR, to provide a more holistic evaluation of capital investment decisions.

Related terms

Net Income: The total revenue minus total expenses of a business over a specific period, representing the profit earned.

Initial Investment Cost: The total amount of capital required to acquire or implement a new asset or project.

Time Value of Money:

The concept that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.