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What Is the Accounting Rate of Return (ARR)?

The annual percentage return (ARR) on an investment is calculated based on the initial cash outlay. The required rate of return (RRR), also known as the hurdle rate, is the minimum return an investor would accept for an investment or project that compensates them for a certain level of risk. Click here and know more about data scientist salary.

Key Takeaways

  • The accounting rate of return (ARR) formula can be used to calculate a project’s annual percentage rate of return
  • ARR is calculated as the average annual profit divided by the initial investment
  • The expected rate of return from each project is provided by ARR, which is commonly used when considering multiple projects
  • One of ARR’s limitations is that it does not distinguish between investments that generate different cash flows over the project’s lifetime
  • ARR is not the same as the required rate of return (RRR), which is the minimum return an investor would accept for an investment.

Understanding the Accounting Rate of Return (ARR)

The accounting rate of return is a capital budgeting metric that can be used to quickly calculate the profitability of an investment. Businesses primarily use ARR to compare multiple projects in order to determine the expected rate of return on each project. 

ARR takes into account any annual expenses, including depreciation, that may be incurred as a result of the project.

How to Calculate the Accounting Rate of Return (ARR)

  1. Calculate the annual net profit from the investment, which could include revenue less any annual costs or expenses associated with the project or investment’s implementation.
  2. If the investment is a fixed asset, such as property, plant, and equipment (PP&E), deduct any depreciation expense from the annual revenue to calculate the annual net profit.
  3. Divide the annual net profit by the asset’s or investment’s initial cost. The calculation’s output will be a decimal. To display the percentage return as a whole number, multiply the result by 100.

Advantages and Disadvantages of the Accounting Rate of Return (ARR)

Advantages

The accounting rate of return is a simple calculation that does not require complex math and is useful in calculating the annual percentage rate of return on a project. Managers can easily compare ARR to the minimum required return as a result of this. For example, if a project’s minimum required return is 12% and its ARR is 9%, a manager will know not to proceed with the project.

ARR is useful when investors or managers need to quickly compare the return on investment of a project without having to consider the time frame or payment schedule, but only the profitability or lack thereof.

Disadvantages

Despite its benefits, ARR has limitations. It does not take into account the time value of money. The concept of time value of money states that money available now is worth more than an identical sum in the future due to its potential earning capacity.

In other words, two investments may result in unequal annual revenue streams. If one project generates more revenue in the early years and the other generates revenue later in the life cycle, ARR does not assign a higher value to the project that generates profits sooner, which can be reinvested to earn more money. Learn more: ca salary in india

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