Accounting Rate of Return (ARR) Meaning and Formula
Accounting Rate of Return (ARR) Meaning – It is the ratio of average of profit after tax to the average investment.
ARR is also known as return on investment. It is a non discounted cash flow method of capital budgeting. In this method, the average investments are equal to half of the original investments, if depreciation is constantly charge. Hence, ARR can also be calculated by dividing book value of the investments by the life of the project. The book value of the investment consists of historical cost of investments minus depreciation.
Accounting Rate of Return (ARR) Formula
ARR = Average Income/ Average Investment
where average income consists of the earnings after deducting interests and taxes or in simple words you can say Net profits after tax.
Accounting Rate of Return Example
A project initial investment costs Rs 50,000. Earnings before depreciation, interest and taxes during first five years are 12000, 14000, 16000, 18000 and 20000 respectively. 50 percent tax rate and charge depreciation on straight line method basis which is 8,000.
| Period | 1 | 2 | 3 | 4 | 5 | Average |
| EBDIT | 12000 | 14000 | 16000 | 18000 | 20000 | 16000 |
| Depreciation | 8,000 | 8,000 | 8,000 | 8,000 | 8,000 | 8,000 |
| EBIT | 4000 | 6000 | 8000 | 10000 | 12000 | 8,000 |
| Taxes @50% | 2000 | 3000 | 4000 | 5000 | 6000 | 4,000 |
| EBIT | 2000 | 3000 | 4000 | 5000 | 6000 | 4,000 |
| Beginning investment | 50000 | 42000 | 34000 | 26000 | 18000 | 34000 |
| Ending Investment | 42000 | 34000 | 26000 | 18000 | – | 24000 |
| Average | 46000 | 38000 | 30000 | 22000 | 9000 | 29000 |
Accounting Rate of Return (ARR) Evaluation
- The method is very simple to understand and easy to calculate and interpret.
- The calculation of ARR is easy and do not require to estimate any cash flows or need any cash flows.
- It includes stream of income in calculating the project’s profitability.
Acceptance Rule for Accounting Rate of Return
According to this method, projects whose ARR is higher than the minimum rate fixed by the management. The management rejects those projects whose ARR is less than the minimum rate. Higher ARR project ranks first and lower ARR project get lowest rank.
Related Financial Terms of Accounting Rate of Return
