Accounting Rate of Return (ARR) Examples

The Accounting Rate of Return (ARR), also known as the Average Rate of Return, is a method used to estimate the rate of return on an investment project. This approach is widely used in capital budgeting to evaluate the potential profitability of a project based on its expected average annual profit relative to the initial investment required. The primary advantage of the ARR is its simplicity, as it uses readily available accounting information, making it accessible and easy to apply for businesses and investors alike. However, despite its popularity and ease of use, the ARR method has certain limitations that can affect the accuracy of the decisions it supports.

In its simplest form, ARR is calculated by dividing the average annual accounting profit of a project by the initial investment cost. The resulting percentage reflects the rate of return that the investment is expected to generate on an annual basis. In general, the higher the ARR, the more attractive the project is perceived to be, as it suggests that the project will generate substantial returns relative to the capital invested. Furthermore, if the ARR exceeds a pre-established benchmark or minimum required rate of return, the project is considered viable and is typically accepted.

The appeal of the ARR method lies in its straightforwardness. Unlike more complex techniques such as the Net Present Value (NPV) or Internal Rate of Return (IRR), which require detailed cash flow projections and the consideration of factors such as the time value of money, ARR relies on basic accounting data, such as profits and investment amounts. This simplicity allows decision-makers, especially those with less experience in financial analysis, to evaluate potential investments without the need for specialized financial knowledge. As a result, it has become a popular tool in many business settings, particularly for small and medium-sized enterprises that may lack access to sophisticated financial modeling tools.

One of the key advantages of the ARR method is that it provides a clear and easily understandable measure of profitability. By comparing the expected average profit with the initial investment, the ARR allows investors to assess the potential return of a project in a relatively simple manner. This makes it particularly useful for businesses that need to make quick decisions or when comparing multiple investment opportunities. If a project has a high ARR, it can be considered an attractive investment, particularly when compared to other opportunities that may have a lower ARR. For instance, an investment with an ARR of 10% would be more appealing than one with an ARR of 4%, assuming that both projects require similar levels of investment and carry comparable risk profiles.

Another advantage of ARR is its ability to provide a standardized way to assess the financial performance of investment projects. By using a common measure of return, businesses can easily compare different projects or investment opportunities, even if they vary in size or scope. This is particularly valuable in situations where multiple projects are being considered at the same time, as it allows for the objective ranking of potential investments based on their expected returns. The ability to use ARR for such comparisons provides decision-makers with a valuable tool to prioritize projects and allocate resources efficiently.

However, while the ARR method has its advantages, it also has significant drawbacks that need to be considered when making investment decisions. One of the most important limitations of ARR is that it does not take into account the time value of money. The time value of money is a fundamental concept in finance that recognizes that the value of money changes over time due to factors such as inflation, interest rates, and the opportunity cost of capital. In simple terms, money received today is worth more than the same amount of money received in the future because it can be invested and earn a return.

In the context of capital budgeting, the lack of consideration for the time value of money means that ARR does not properly account for the fact that future cash flows are worth less than present cash flows. This can lead to a distorted view of a project's profitability, particularly for long-term investments where profits are spread out over many years. For example, a project that generates a steady stream of profits over a long period may appear to have a higher ARR than another project that generates larger profits in the short term, even though the latter may provide a greater return in present value terms. As a result, relying solely on ARR can lead to suboptimal investment decisions, particularly for projects with cash flows that occur far into the future.

Another disadvantage of the ARR method is that it is based on accounting profits rather than cash flows. Accounting profits are calculated by adjusting revenues for various expenses, such as depreciation, taxes, and interest, but they do not reflect the actual cash inflows and outflows that a project generates. This can be problematic because accounting profits can be influenced by non-cash items such as depreciation, which reduces profits but does not affect the cash flow of a project. Additionally, accounting profits can be affected by changes in accounting policies or estimates, such as the method of depreciation used, which can lead to inconsistencies in the way profitability is measured across different projects.

Because ARR focuses on accounting profits, it may fail to provide an accurate representation of the actual financial performance of a project. For example, a project that generates high accounting profits but suffers from significant cash flow issues may be rated highly by the ARR method, even though it may not be a good investment from a cash flow perspective. This can lead to misleading conclusions and poor investment decisions. As such, while ARR may provide a rough estimate of a project’s potential profitability, it should not be relied upon exclusively for capital budgeting decisions.

The ARR method also has the limitation of not considering the risks associated with a project. Different investment projects carry different levels of risk, depending on factors such as market conditions, competition, and regulatory changes. However, ARR does not adjust for these risks, meaning that it treats all projects as if they were equally safe or risky. As a result, projects with high risks may be rated similarly to projects with low risks, which can lead to the acceptance of investments that are not appropriate for a company’s risk tolerance. In practice, decision-makers often need to consider risk-adjusted returns, and methods such as the Internal Rate of Return (IRR) or the Net Present Value (NPV) allow for a more nuanced evaluation of risk and return.

Furthermore, the ARR method may fail to account for the size of an investment project. ARR expresses the profitability of a project as a percentage of the initial investment, but it does not consider the absolute scale of the project. This means that a smaller project with a high ARR may be ranked more favorably than a larger project with a lower ARR, even though the larger project may generate more total profit in dollar terms. This can lead to an overemphasis on smaller projects that offer high returns relative to their cost but fail to contribute significantly to the overall financial performance of the business.

Despite these drawbacks, the ARR method remains a useful tool for evaluating investment opportunities, particularly in situations where simplicity and ease of understanding are important. It is a popular choice for businesses that need to quickly assess the potential profitability of an investment and compare it to other opportunities. However, the limitations of ARR, especially its failure to consider the time value of money and its reliance on accounting profits, mean that it should not be used in isolation when making important investment decisions. Instead, it is best used in conjunction with other financial evaluation methods, such as NPV or IRR, that take into account cash flows, risk, and the time value of money to provide a more comprehensive picture of a project’s financial viability.

Calculation and Formula:
ARR = Average profit / Average investment

Example 1:
An investment of $600,000 is expected to give returns as follows: Year 1 ($50,000), Year 2 ($150,000), Year 3 ($80,000), Year 4 ($20,000).Calculate the average rate of return.
Solution:
Total returns over the four years = 50,000 + 150,000 + 80,000 + 20,000 = $300,000
Average returns per annum = 300,000 / 4 = $75,000
ARR = 75,000 / 600,000 = 12.5%

Example 2:
Western Ltd has an option of two projects: C and D, with the same initial capital investment of $100,000. The profits for both projects are as follows:
Project C: Year 1 ($10,000), Year 2 ($5,000), Year 3 ($15,000)
Project D: Year 1 ($12,000), Year 2 ($11,000), Year 3 ($4,000)
The estimated resale value of both projects at the end of year 3 is $22,000. Calculate the ARR for each project and advise the firm.
Solution:
For Project C:
Average profit = (10,000 + 5,000 + 15,000) / 3 = $10,000
Average investment = (100,000 + 22,000) / 2 = $61,000
Accounting rate of return = 10,000 / 61,000 = 16.39%

For Project D:
Average profit = (12,000 + 11,000 + 4,000) / 3 = $9,000
Accounting rate of return = 9,000 / 61,000 = 14.75%

Since Project C has a higher ARR, it should be chosen.