I nv est ment s Deci si ons Account i ng Rat e of Ret ur n ( ARR)

2010 ht t p: / / w w w .w eal l st ar t somew her e.com

1
Cal cul at i ng Account i ng Rat e of Ret ur n


ARR =
Average Net PruItt
Average Buuh Value



The account ing rat e of ret urn simply involves using account ing numbers,
average net pr ofit coming fr om a companys income st at ement and
average book value of t he invest ment coming from t he companys
balance sheet . These t wo account ing figures divided t oget her gives as
t he account ing rat e of ret urn.

Management will usually have a predet ermined ARR measure. I f t he
calculat ed ARR is great er t han t he ARR set by management t hen t he
proj ect should accept ed. For example if management want an invest ment
t o have a ARR of 15% and t he calculat ed ARR is 20% t hen t he proj ect ed
would be accept ed.

Ex ampl e 1
A company want s t o det ermine by way of ARR if building a const ruct ion plant is
wort hwhile. The init ial cost of t he plant is $300, 000. The plant will be
depreciat ed each year over it s useful life of 3 years.

Year 1 Year 2 Year 3
Revenue 200, 000 $300, 000 $350, 000
Ex penses $50, 000 $60, 000 $75, 000
Depr eci at i on 100, 000 $100, 000 $100, 000
Ear ni ngs bef or e t ax $50, 000 $140, 000 175, 000
Tax ed @ 30% $15, 000 $42, 000 52, 500
Net Pr of i t $35, 000 $98, 000 122, 500


The average net profit is easy t o calculat e. I t is simply adding up t he net profit
t he company is expect ed t o make over t he next 3 years and dividing it by 3.

Aveige net piofit =
$SS,uuu + $98,uuu + $122,Suu
S


Aveige net piofit = $8S,166.67

The average book value is t he simply t he average value of t he invest ment over
t he 3 year period. So in year 0 t he plant is wort h $300, 000, in year 1 t he plant
is wort h $200, 000, in year 2 t he plant is wort h $100, 000 and by t he end of t he
3
rd
year t he plant is wort h $0.

Aveige book value of investment =
$Suu,uuu + $2uu,uuu +$1uu,uuu +u
4


Aveige book value of investment = $1Su,uuu
I nv est ment s Deci si ons Account i ng Rat e of Ret ur n ( ARR)

2010 ht t p: / / w w w .w eal l st ar t somew her e.com
2

ARR =
Aveiage Net Piofit
Aveiage Book value


ARR =
$8S,166.67
$1Su,uuu


ARR = u.S678 oi S6.78%

The account ing rat e of ret urn on t he invest ment is 56. 78%. I f
management had set an accept able ARR of 40% t hen t he proj ect should
be accept ed. I f management set an accept able ARR of 60% t hen t he
proj ect would be rej ect ed.

Adv ant ages of ARR

Easy t o calculat e as account ing informat ion will always be available
in t he companys books.

I t consider s income over t he whole life of t he asset .

Di sadvant ages of AAR

I t ignores t hat t ime value of money. No discount ing involved when
comput ing ARR unlike t he NPV

I t doesnt use cash flows generat ed by t he proj ect .

I t does not explicit ly r ecognise risk.

Whet her t o accept or rej ect is not guided by any formal model

Does not t ell us how much t he value of t he firm will increase by
t aking on t he proj ect or t he increase in wealt h of shareholders.

There are far more disadvant ages t han advant ages when using t he
account ing rat e of ret urn t o det ermine if a proj ect should go accept ed or
not . I n fact it is a very poor measure t o use if t rying t o det ermine if a
proj ect will pay off.