The Accounting Rate of Return (ARR) is a method used to estimate the rate of return from an investment by employing a straightforward, non-discounted approach. Unlike more sophisticated methods that incorporate the time value of money through discounting, the ARR uses a simple formula that totals investment inflows, subtracts investment costs to derive profit, and then divides the profit by the number of years invested and by the investment cost to estimate an annual rate of return.
Calculating ARR
ARR Formula
The formula for ARR is:
Steps to Calculate ARR
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Calculate Average Annual Profit:
$$ \text{Average Annual Profit} = \frac{\text{Total Profit over Life of Investment}}{\text{Number of Years}} $$ -
Determine Initial Investment: This is the initial amount of money invested in the project.
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Apply the ARR Formula: Input the average annual profit and initial investment into the ARR formula.
Example
Let’s say a company invests $100,000 in a project, and it expects to make $20,000 per year for 5 years. The calculation would be:
- Total Profit = $20,000 \times 5 = $100,000
- Average Annual Profit = $100,000 / 5 = $20,000
- ARR Calculation:
$$ ARR = \left( \frac{\$20,000}{\$100,000} \right) \times 100 = 20\% $$
So, the ARR in this case is 20%.
Comparison with Discounted Methods
Simplicity vs. Sophistication
- Simplicity: ARR is straightforward, easy to compute, and does not require understanding of more complex concepts like discount rates or the time value of money.
- Limited Insight: ARR does not account for the timing of cash flows, which can lead to less accurate assessments, especially for long-term projects or varying cash flows.
Discounted Methods
- Net Present Value (NPV): Considers the time value of money by discounting future cash flows back to their present value.
- Internal Rate of Return (IRR): The discount rate that makes the net present value of all cash flows equal to zero.
Related Terms
- Return on Investment (ROI): A measure of the profitability of an investment.
- Net Present Value (NPV): The value of a series of future cash flows discounted back to their present value.
- Internal Rate of Return (IRR): The discount rate that equates the net present value of cash flows to zero.
FAQs
What are the limitations of ARR?
In what scenarios is ARR most useful?
How does ARR compare to IRR and NPV?
References
Summary
The Accounting Rate of Return (ARR) provides a straightforward method for estimating an investment’s return without considering the time value of money. While it is easy to use, its lack of sophistication and inability to account for variable cash flows and investment risk make it less reliable compared to modern discounted methods such as NPV and IRR. Despite its limitations, ARR remains a useful tool for preliminary investment evaluations.
