Accounting rate of return

Balasundar.D(10ac07)
MBA 1st year , sec-”c”

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Definition

A measure of profitability which relates income

and investment,both measured in accounting terms

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Generalisation
 The accounting rate of return tends to understate the internal rate of
returnfor earlier years and overstate it for later years.

 The accounting rate of return and the internal rate of return can be the
same only if the depreciation schedule is equal to the economic
depreciation schedule

 Inflation and creating account tend to create a discrepancy between the

accounting rate of return and the internal rate of return.

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 Cont…

Average rate of return

Average annual net income after tax & depreciation

average investment

where,

Average investment={original investment-scrap value)/2}

+additional working capital +scrap value

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 Calculation criteria
 Compare accounting rate of return to company’s
required minimum rate of return for investments of
similar risk.
 The minimum return is based on the company’s cost
of capital.

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 Decision rule
 A project is acceptable if its rate of return is greater
than management’s minimum rate of return.

 The higher the rate of return for a given risk, the

more attractive the investment.

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  A machine was purchased for $10,000.  The net income from the
machine is as follows:

Year 1                 $3,000

Year 2                  2,000
Year 3                  1,000

depreciation= $500

Calculate the accounting rate of return.

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 Solution

ARR= PATD/OI

= (6000+500)/10000

=.65 = 65%

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Formulae

Accounting rate of return

Average annual net income after tax & depreciation

Original investment

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Merits
 Simple to calculate

 Considers benefits over the entire life of project

 Facilitates post auditing of capital financial accounts

 Applicable even when benefits over the entire life of the project is not
available

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 Demerits

 Based o accounting profit.Does not

consider cash flow

 Time value of money???

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 References

 Projects- Prasnna Chandra

 www.Investorsco.com

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 Thank you

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