Understanding the Term: Accounting Rate of Return
The Accounting Rate of Return or ARR is the rate of return that a company or an investor will earn on his investment with regards to the initial outlay or investment over the period of investment. It is a simple formula in which we divide the net income from an investment over a particular period of time from its initial investment. We express the ARR as a percentage. The calculation of the ARR helps the project managers to choose the best project out of several options that are available to the Company for investment. They will pick the project with the highest ARR.
ARR is an investment appraisal technique. It is especially useful in the case of long-term projects in which choosing the right project is of paramount importance. A faulty choice can result in heavy losses to any company. ARR helps to ascertain the returns from several long-term project options, compare them and choose the best among them. Also, it helps to determine whether or not to invest in an item of particular capital expenditure. Any company will like to first ascertain the returns from any proposed capital expenditure before incurring it. ARR is a simple measure that helps managers to decide between the available choices of capital expenditures. Companies can also use it to make a choice between the available options in case of acquisitions of a company or an asset. Thus, ARR is very helpful in making capital budgeting decisions.
- Understanding the Term: Accounting Rate of Return
- Calculation of Accounting Rate of Return
- Is there any Minimum Acceptable Accounting Rate of Return?
- Advantages of the Accounting Rate of Return
- Disadvantages of the Accounting Rate of Return
Calculation of Accounting Rate of Return
We can calculate the accounting rate of return by using the following formula:
|ARR = Average net profit / Initial investment|
Here, the average net profit is the profit that the company makes from an investment or a project after the deduction of all the expenses associated with the project. The expenses will include the operating expenses, taxes, and interest that the company will pay for the implementation of that project. We also take into account the annual depreciation amount in case of fixed assets or machinery, etc. The quantum of depreciation is also deducted from the annual profits to arrive at the final net profit/net return the investment is going to fetch.
Also, we take the average of the net profits earned over the years during the investment period. To calculate the average net profit, we divide the total profits that the company makes from that project by the number of years into consideration.
For a better understanding of the concept, let us take an example of ARR. Let us suppose that a company invests in a new machine that costs $100000. The machine has a life of 5 years. The machine has so salvage value. This means that the company will not earn any amount when it disposes of the machinery at the end of the fifth year. The machine will help the company to make a profit of $40000 for the first two years, $30000 in the third year, and $20000 in the fourth and fifth year respectively.
In order to find out if the above investment will be feasible for the company or not, let us calculate its ARR.
Total profits that the machine will help the company to make over its lifetime
1st Year Profit + 2nd year profit + 3rd year profit + 4th year profit + 5th year profit
= $40000 + $40000 + $30000+ $20000 + $20000
Total depreciation expense over the lifetime of the machine = Total Machinery Value – Salvage value
= $100000 – 0 = $100000
Hence, total profits in the five years= $150000 – $100000= $50000.
Average annual profit = Total Profits/No. of years
= $50000/5 years = $10000
ARR = ($10000/ $100000)x 100 = 10%.
Therefore, the ARR of the machine is 10%.
Is there any Minimum Acceptable Accounting Rate of Return?
Companies and project managers usually set a “hurdle rate” for an investment on the basis of its risk and its risk tolerance before embarking upon any fresh investment. We can call this the minimum rate the company is looking for from any project or investment that it takes up. This minimum rate we call also the “required rate of return” (RRR). The ARR of a project should be higher than the company’s required rate of return for a project to be feasible.
However, the hurdle rate is dynamic in nature and keeps varying depending upon the risk involved in the project. Also, the risk tolerance of the company or an investor can also change from time to time. Therefore, there is no minimum acceptable ARR as such. It is also dynamic and keeps changing from one project or investment to other.
The only thing that is a constant and guiding factor is that the ARR should always be above the RRR considering the time, risk and investment.
Advantages of the Accounting Rate of Return
Easy to Use
The ARR is very simple to calculate. It does not involve any complex and elaborate calculations. Moreover, it is very easy to understand and use in any given situation. This gives an instant idea to the management whether to accept or reject any investment proposition based on the ARR worked out. They need to just compare it with the RRR for making the decision. The interpretation is so simple that even a layman can easily understand it.
Accountability for Depreciation
The concept of ARR takes into account even the non-cash expenditures such as depreciation and amortization. Hence, it tells the returns from any capital asset investment in the true sense.
Disadvantages of the Accounting Rate of Return
While the concept of ARR is very easy to use, there are a number of disadvantages of this method too.
Ignores the Time Value of Money
This is one of the biggest drawbacks of the ARR. A very important concept of the financial world “time value of money” is completely ignored in this method of prioritizing. According to the concept, a sum of money in hand is more valuable than the same sum of money after some period of time. This is so because an investor can invest the money in hand at present and earn interest or revenue from it. Thus under this method even if the profits are higher in the initial years or in the later years makes no difference. Because average return would put both the investments at par. Thus the project giving earlier profits should have been preferred in general. But that priority is not accorded to the project under this method.
Ignores the Cash Flow
The concept and calculation of ARR are based upon the net profits after meeting all the cash and non-cash expenditures. And in the process, it completely ignores the cash flow. The calculation of ARR is not affected by how early or late an investment provides returns. For example, an investment may provide nil or very limited returns in its early life. It may provide good returns in the later years. Hence, the investment will provide usable funds only in its later years. However, the ARR will be the same even if the situation is reversed and it provides better returns in the initial years. Logically the second case will be better and preferable for any sane investor. ARR totally ignores the time value of money.
Ignores Risk and Uncertainty
The concept of ARR does not consider the risk and uncertainty that will come along with any investment. It treats all of them likewise. The risk in any project can vary on the basis of its duration, nature of work, work environment, etc. Any investor will like to minimize his risks, even if the returns from an investment go down a little. ARR ignores such factors and just tells which project is better on the sole basis of the returns from it.
Multiple Time Frame for Investments
This method is not useful for evaluating projects where the capital investment in the project takes place at different times over the years. It only calculates the overall profits and average return irrespective of when and what quantum of investments have been made.
The accounting rate of return is undoubtedly a simple and useful metric to evaluate, compare and choose the best among a number of capital expenditure options and projects. Every investor’s sole aim is to maximize his profitability. ARR totally takes care of it and helps to pick the best option with the highest returns.
However, it does ignore a number of important metrics such as the time value of money, risk in comparison to the returns, the overall compatibility of a project in the company environment and its operations, etc. Therefore, we should use ARR only as one of the tools of evaluation of an investment or a project and not just the only tool. Also, it will work better with investment options that are short-term in nature so as to minimize the impact of delayed cash flow and the time value of money.