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The Accounting Rate of Return - (ARR)

The accounting rate of return (ARR) method is used to estimate the expected return on a capital project based on its accounting profits. It involves dividing the average annual accounting profit by the initial investment. While simple to calculate, it has disadvantages like not considering timing of cash flows or the time value of money. Despite limitations, the payback period and ARR methods remain widely used in practice due to their ease of use and ability to rank projects.

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439 views2 pages

The Accounting Rate of Return - (ARR)

The accounting rate of return (ARR) method is used to estimate the expected return on a capital project based on its accounting profits. It involves dividing the average annual accounting profit by the initial investment. While simple to calculate, it has disadvantages like not considering timing of cash flows or the time value of money. Despite limitations, the payback period and ARR methods remain widely used in practice due to their ease of use and ability to rank projects.

Uploaded by

Kathlaine Mae Oba
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© © All Rights Reserved
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The accounting rate of return - (ARR)

The ARR method (also called the return on capital employed (ROCE) or the return on
investment (ROI) method) of appraising a capital project is to estimate the accounting rate of
return that the project should yield. If it exceeds a target rate of return, the project will be
undertaken.

Note that net annual profit excludes depreciation.

Example:

A project has an initial outlay of $1 million and generates net receipts of $250,000 for 10 years.

Assuming straight-line depreciation of $100,000 per year:

= 15%

= 30%

Disadvantages:

 It does not take account of the timing of the profits from an investment.

 It implicitly assumes stable cash receipts over time.

 It is based on accounting profits and not cash flows. Accounting profits are subject to a
number of different accounting treatments.

 It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment.
 It takes no account of the length of the project.

 it ignores the time value of money.

The payback and ARR methods in practice

Despite the limitations of the payback method, it is the method most widely used in practice.
There are a number of reasons for this:

 It is a particularly useful approach for ranking projects where a firm faces liquidity constraints
and requires fast repayment of investments.

 It is appropriate in situations where risky investments are made in uncertain markets that are
subject to fast design and product changes or where future cash flows are particularly difficult to
predict.

 The method is often used in conjunction with NPV or IRR method and acts as a first screening
device to identify projects which are worthy of further investigation.

 it is easily understood by all levels of management.

 It provides an important summary method: how quickly will the initial investment be recouped?

Now attempt exercise 6.5.

Exercise 6.5 Payback and ARR: Delta Corporation is considering two capital expenditure
proposals. Both proposals are for similar products and both are expected to operate for four
years. Only one proposal can be accepted.

The following information is available:

Profit/(loss)
Proposal A Proposal B
$ $
Initial investment 46,000 46,000
Year 1 6,500 4,500
Year 2 3,500 2,500
Year 3 13,500 4,500
Year 4 Loss 1,500 Profit 14,500
Estimated scrap value at the end of Year 4 4,000 4,000

Depreciation is charged on the straight line basis. Problem:

a) Calculate the following for both proposals:

i) the payback period to one decimal place


ii) the average rate of return on initial investment, to one decimal place.
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