This document defines accounting rate of return (ARR) as the ratio of estimated accounting profit to average investment of a project. It ignores the time value of money. The document provides the formula to calculate ARR using average accounting profit and initial investment. It gives examples calculating ARR for projects with cash inflows, depreciation, and salvage values. The decision rule is to accept projects with ARR not less than the required rate of return, or for mutually exclusive projects, the one with the highest ARR. The advantages are its ease of calculation and recognition of profitability, while the disadvantages are ignoring time value of money and potential inconsistencies in calculation.

1. Rate of Return

2. Definition
 Accounting rate of return or simple rate of return is the
ratio of the estimated accounting profit of a project to its
average investment.
 It is an investment appraisal technique.
 ARR ignores the time value of money.

3. Formula
 Accounting Rate of Return is calculated as follows:
ARR = Average Accounting Profit
Initial Investment

4. Formula……..
 Average accounting profit is the arithmetic mean of
accounting income expected to be earned during each year
of the project's life time. Initial investment is sometimes
replaced by average investment due to the reason that the
book value of the project usually declines over its life
time. Average investment is calculated as the sum of the
beginning and ending book value of the project divided by
2.

5. Decision Rule
 Accept the project only if its ARR is NOT less than the
required accounting rate of return. In case of mutually
exclusive projects, accept the one with highestARR.

6. Examples
 Example 1:
An initial investment of Rs130,000 is expected
to generate annual cash inflow of Rs32,000 for 6 years.
Depreciation is to be allowed on the straight line basis. It
is estimated that the project will generate a scrap amount
of Rs10,500 at end of the 6th year. Calculate its accounting
rate of return assuming that there are no other expenses on
the project.

7. Example 1
 Solution :
Annual Depreciation = ( Initial Investment − Scrap Value )
/ Useful Life in Years
Annual Depreciation = ( Rs130,000 − Rs10,500 ) / 6 ≈
Rs19,917
Average Accounting Income = Rs32,000 − Rs19,917=
Rs12,083
Accounting Rate of Return = Rs12,083 / Rs130,000 ≈
9.3%

8. Example 2
 Compare the following two exclusive projects on the basis
of ARR. Cash flows and salvage values are in thousands
of Rupees. Use the straight line depreciation method.
 ProjectA:
 Year 0 1 2 3
 Cash Outflow -220
 Cash Inflow 91 130 105
 Salvage Value 10

9. Example 2…….
 Solution
 ProjectA:
 Step 1: Annual Depreciation = ( 220 − 10 ) / 3 = 70
 Step 2: Year
Cash Inflow
Salvage Value
Depreciation*
Accounting Income 21
1 2 3
91 130 105
10
-70 -70 -70
60 45

10. Example 2…….
 Step 3:
Average Accounting Income = ( 21 + 60 + 45 ) / 3
= 42
 Step 4:
Accounting Rate of Return = 42 / 220
= 19.1%

11. Example 2…….
Project B:
Year 0 1 2 3
Cash Outflow -198
Cash Inflow 87 110 84
Salvage Value 18

12. Example 2…….
 Project B:
 Step 1: Annual Depreciation = ( 198 − 18 ) / 3
= 60
1 2 3
87 110 84
18
 Step 2: Year
Cash Inflow
Salvage Value
Depreciation*
Accounting Income
-60 -60 -60
27 50 42

13. Example 2
 Step 3:
Average Accounting Income = ( 27 + 50 + 42 ) / 3
= 39.666
 Step 4:
Accounting Rate of Return = 39.666 / 198 ≈ 20.0%
 Since the ARR of the project B is higher, it is more
favorable than the projectA.

14. Advantages and Disadvantages
Advantages
Like payback period, this method of
investment appraisal is easy to calculate.
It recognizes the profitability factor of
investment.

15. Disadvantages
 It ignores time value of money. Suppose, if we use
ARR to compare two projects having equal initial
investments. The project which has higher annual
income in the latter years of its useful life may rank
higher than the one having higher annual income in
the beginning years, even if the present value of the
income generated by the latter project is higher.
 It can be calculated in different ways. Thus there is
problem of consistency.

16. Thank You