Accounting Rate of Return mefielding.com1

Definition  Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal. mefielding.com2

Formula  Accounting Rate of Return is calculated using the following formula: Average Accounting Profit  ARR = Average Investment mefielding.com3

Decision Rule  Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR. mefielding.com4

Examples  Example 1: An initial investment of $5.2M is expected to generate annual cash inflow of $1.2M for 5 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $420,000 at end of the 5th year. Calculate its accounting rate of return assuming that there are no other expenses on the project. mefielding.com5

solution Average Accounting Profit  ARR = Average Investment Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years Annual Depreciation = (5,200,000 − 420,000) ÷ 5 ≈ 956,000 Average Accounting Profit = 1,200,000 − 956,000 = 244,000 Accounting Rate of Return = 244,000 ÷ 5,200,000 ≈ 4.69% mefielding.com6

Example  The 4 Pillars Clothing Factory wants to replace an old machine with a new one. The old machine can be sold to a small factory for $400,000. The new machine would increase annual revenue by $6,000,000 and annual operating expenses by $2,400,000. The new machine would cost $14,400,000. The estimated useful life of the machine is 12 years with zero salvage value. Required:  Compute accounting rate of return of the machine using above information.  Should 4 Pillars Clothing Factory purchase the machine if management wants an accounting rate of return of 15% on all capital investments? mefielding.com7

Solution Average Accounting Profit  ARR = Average Investment  = 2,400,000 * / 14,000,000**  = 17.14% * Average Accounting Profit Incremental revenues – Incremental expenses including depreciation 6,000,000-(2,400,000+1,200,000) =6,000,000-3,600,000 = 2,400,000 ** The amount of initial investment has been reduced by net realizable value of the old machine ( 14,400,000 – 400,000)= 14,000,000 mefielding.com8

Comparison of different alternatives:  A manufacturing company has the following different alternative investment proposals: Kten’s Proposal Ren’s Proposal Maw’s Proposal Expected incremental income per year (a) 2,000,0003,000,0003,600,000 Initial investment (b) 10,000,00012,000,00020,000,000 Expected accounting rate of return (a)/(b) mefielding.com9