Accounting or Average Rate of Return
Average accounting return, also termed as accounting rate of return or ARR, is an accounting method utilized for the purposes of comparison with other capital budgeting calculations, like NPV, PB period and IRR.
ARR gives a quick estimate of a project''s worth over its useful life. ARR is computed by finding a capital investment''s average operating profits before interest and taxes but after depreciation and amortization (also known as "EBIT") and dividing that number by the book value of the average amount invested. It can be illustrated as the following:
ARR = Average Profit / Average Investment
The result is expressed in percentage. In other words, ARR compares the amount invested to the profits earned over the course of life of a project. The higher the ARR, the better the life of project.
The main disadvantages of ARR are as follows:
1. It employs operating profit rather than cash flows. A number of capital investments have high upkeep and maintenance costs that bring down profit levels.
2. Not like NPV and IRR, it does not account for the time value of money. Through ignoring the time value of money, the capital investment under consideration will appear to attain a higher level of return than what will take place in reality. The capital investment may appear to be more lucrative than the alternatives, like investing in the financial markets, when it is actually less lucrative.
Here is a simple instance of an ARR calculation: A project requiring an average investment of $1,000,000 and generating an average annual profit of $150,000 would have an ARR of 15%.
Whereas ARR is easy to calculate and can be used to gauge the results of other capital budgeting calculations, it is not the most accurate metric.