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ARR - Accounting Rate of Return

The document defines Accounting Rate of Return (ARR) as the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. It is used to evaluate whether capital investment projects will earn a return that meets or exceeds the required rate of return. The document provides the ARR formula and two examples to demonstrate how to calculate ARR. It notes some limitations to using ARR, including that it ignores the time value of money and risk considerations.

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242 views

ARR - Accounting Rate of Return

The document defines Accounting Rate of Return (ARR) as the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. It is used to evaluate whether capital investment projects will earn a return that meets or exceeds the required rate of return. The document provides the ARR formula and two examples to demonstrate how to calculate ARR. It notes some limitations to using ARR, including that it ignores the time value of money and risk considerations.

Uploaded by

ADEKE MERCY
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ARR – Accounting Rate of Return

Rate of return from an accounting perspective

Written by CFI Team


Updated January 30, 2022

What is ARR – Accounting Rate of Return?

Accounting Rate of Return (ARR) is the average net income an asset is expected to
generate divided by its average capital cost, expressed as an annual percentage.
The ARR is a formula used to make capital budgeting decisions. It is used in
situations where companies are deciding on whether or not to invest in an asset (a
project, an acquisition, etc.) based on the future net earnings expected compared to
the capital cost.

To learn more, launch our financial analysis courses!


ARR Formula

The formula for ARR is:

ARR = Average Annual Profit / Average Investment

Where:

 Average Annual Profit = Total profit over Investment Period / Number of


Years
 Average Investment = (Book Value at Year 1 + Book Value at End of
Useful Life) / 2

Components of ARR

If the ARR is equal to 5%, this means that the project is expected to earn five cents
for every dollar invested per year.

In terms of decision making, if the ARR is equal to or greater than a company’s


required rate of return, the project is acceptable because the company will earn at
least the required rate of return.

If the ARR is less than the required rate of return, the project should be rejected.
Therefore, the higher the ARR, the more profitable the company will become.

Read more about hurdle rates.

ARR – Example 1

XYZ Company is looking to invest in some new machinery to replace its current
malfunctioning one. The new machine, which costs $420,000, would increase
annual revenue by $200,000 and annual expenses by $50,000. The machine is
estimated to have a useful life of 12 years and zero salvage value.

Step 1: Calculate Average Annual Profit


Inflows, Years 1-12
(200,000*12) $2,400,000
Less: Annual Expenses
(50,000*12) -$600,000
Less: Depreciation -$420,000
Total Profit $1,380,000
Average Annual Profit
(1,380,000/12) $115,000
 

Step 2: Calculate Average Investment


Average Investment
($420,000 + $0)/2 = $210,000
 

Step 3: Use ARR Formula


ARR = $115,000/$210,000 = 54.76%

Therefore, this means that for every dollar invested, the investment will return a
profit of about 54.76 cents.

  

ARR – Example 2

XYZ Company is considering investing in a project that requires an initial


investment of $100,000 for some machinery. There will be net inflows of $20,000
for the first two years, $10,000 in years three and four, and $30,000 in year five.
Finally, the machine has a salvage value of $25,000.

Step 1: Calculate Average Annual Profit


Inflows, Years 1 & 2
(20,000*2) $40,000
Inflows, Years 3 & 4
(10,000*2) $20,000
Inflow, Year 5 $30,000
Less: Depreciation
(100,000-25,000) -$75,000
Total Profit $15,000
Average Annual Profit
(15,000/5) $3,000
 

Step 2: Calculate Average Investment


Average Investment
($100,000 + $25,000) / 2 = $62,500
 

Step 3: Use ARR Formula


ARR = $3,000/$62,500 = 4.8%

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Limitations to Accounting Rate of Return

Although ARR is an effective tool to grasp a general idea of whether to proceed


with a project in terms of its profitability, there are several limitations to this
approach:

 It ignores the time value of money. It assumes accounting income in future


years has the same value as accounting income in the current year. A better
metric that considers the present value of all future cash flows is NPV and
Internal Rate of Return (IRR).
 It does not consider the increased risk of long-term projects and the
increased variability associated with prolonged projects.
 It is only a financial guide for projects. Sometimes projects are proposed and
implemented to enhance other important variables such as safety,
environmental concerns, or governmental regulations.
 It is not an ideal comparative metric between projects because different
projects have different variables such as time and other non-financial factors
to consider.

To learn more, launch our financial analysis courses!

Additional Resources

We hope the above article has been a helpful guide to understanding the
Accounting Rate of Return, the formula, and how you can use it in your career. To
keep learning and advancing your career these additional CFI resources will be
helpful:

 Internal Rate of Return (IRR)


 Goodwill Impairment Accounting
 Modified Internal Rate of Return (MIRR)
 Financial Modeling Guide

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