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. ARR is calculated by dividing average accounting profit by initial investment. Average accounting profit is the mean of annual profits over the project life. Initial investment may be replaced by average investment due to declining book value over time. Projects are accepted if their ARR is not less than the required rate of return. Examples show calculating ARR for projects with given cash flows. ARR is an easy method but ignores the time value of money and can be calculated inconsistently using accounting versus cash flows.

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 highest ARR.

6. Examples
 Example 1:
An initial investment of $130,000 is expected
to generate annual cash inflow of $32,000 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 $10,500 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 = ( $130,000 − $10,500 ) / 6 ≈
$19,917
Average Accounting Income = $32,000 − $19,917 =
$12,083
Accounting Rate of Return = $12,083 / $130,000 ≈ 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 dollars. Use the straight line depreciation method.
 Project A:

Year
 Cash Outflow
 Cash Inflow
 Salvage Value
0 1
-220
91
2
3
130 105
10

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

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

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

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

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. Disadvantages
 It uses accounting income rather than cash flow
information. Thus it is not suitable for projects which
having high maintenance costs because their viability
also depends upon timely cash inflows.

17. Thank You