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Accounting Rate Of Return (ARR)

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Accounting Rate Of Return (ARR)

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Accounting Rate of Return (ARR)

 

Accounting rate of return (ARR) is the return on investment based on specific project. It is calculated by dividing accounting profit after depreciation but before interest and tax (PBIT) with average capital invested.

 

Formula of ARR

 

Accounting Rate of Return Formula

Average Capital Employed

 

Average capital employed is calculated by taking average of cost of asset and residual value of asset and then working capital is added.

 

Formula of Average Capital Employed

 

Average Capital Employed formula

Example: 

A company is considering a project which requires investment on the machinery amounted to Rs.150,000. The machinery life is four years having scrap value of Rs.30,000. Additional capital requirement for the project is Rs.20,000.

The expected project before depreciation are as follows:

-Y1                    Rs.52,000

-Y2                    Rs.55,000

-Y3                    Rs.48,000

-Y4                    Rs.27,000

The company requires ARR of 13% for the project.

Answer: 

Total Project Profit before depreciation

Rupees

 

 

Year 1

52,000

Year 2

55,000

Year 3

48,000

Year 4

27,000

Total Profit

182,000

Depreciation (150,000-30,000)

(120,000)

Profit after depreciation

62,000

Project Period (divide by 4 years)

4

Average accounting profit

15,500

Average capital employed (150,000+30000/2+20,000)

110,000

ARR (15,500 / 110,000)

14.09%

The return on the project as per ARR is 14.09% against company’s required return of 13%. The company should accept the project.

 

Advantages

  • Easy to understand and easy to calculate.

 

Disadvantages 

  • It is based on accounting profit and not on cash flows.
  • It ignores the time value of money

 

Audience:

 

The article is for students who wants to learn basic concept of accounting rate of return (ARR). It is  helpful also for finance professionals who just want to revise this topic. The readers an understand the basic topic with the help of simple example and use the topic whenever needed for studies and in practical life. 

Articles related to this topic:

 

Payback period

Time value of money (Compounding and Present Value (PV))

Internal rate of return

Modified internal rate of return

Ali Murtaza

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