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What is ARR – Accounting Rate of Return?
Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. The ARR is a formula used to make capital budgeting decisions. It is used in situations where companies are deciding on whether or not to invest in an asset (a project, an acquisition, etc.) based on the future net earnings expected compared to the capital cost.
ARR Formula
The formula for ARR is:
ARR = Average Annual Profit / Average Investment
Where:
Average Annual Profit = Total profit over Investment Period / Number of Years
Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2
If the ARR is equal to 5%, this means that the project is expected to earn five cents for every dollar invested per year.
In terms of decision making, if the ARR is equal to or greater than a company’s required rate of return, the project is acceptable because the company will earn at least the required rate of return.
If the ARR is less than the required rate of return, the project should be rejected. Therefore, the higher the ARR, the more profitable the company will become.
XYZ Company is looking to invest in some new machinery to replace its current malfunctioning one. The new machine, which costs $420,000, would increase annual revenue by $200,000 and annual expenses by $50,000. The machine is estimated to have a useful life of 12 years and zero salvage value.
Step 1: Calculate Average Annual Profit
Inflows, Years 1-12
(200,000*12)
$2,400,000
Less: Annual Expenses
(50,000*12)
-$600,000
Less: Depreciation
-$420,000
Total Profit
$1,380,000
Average Annual Profit
(1,380,000/12)
$115,000
Step 2: Calculate Average Investment
Average Investment
($420,000 + $0)/2 = $210,000
Step 3: Use ARR Formula
ARR = $115,000/$210,000 = 54.76%
Therefore, this means that for every dollar invested, the investment will return a profit of about 54.76 cents.
ARR – Example 2
XYZ Company is considering investing in a project that requires an initial investment of $100,000 for some machinery. There will be net inflows of $20,000 for the first two years, $10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage value of $25,000.
Step 1: Calculate Average Annual Profit
Inflows, Years 1 & 2
(20,000*2)
$40,000
Inflows, Years 3 & 4
(10,000*2)
$20,000
Inflow, Year 5
$30,000
Less: Depreciation
(100,000-25,000)
-$75,000
Total Profit
$15,000
Average Annual Profit
(15,000/5)
$3,000
Step 2: Calculate Average Investment
Average Investment
($100,000 + $25,000) / 2 = $62,500
Step 3: Use ARR Formula
ARR = $3,000/$62,500 = 4.8%
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Limitations to Accounting Rate of Return
Although ARR is an effective tool to grasp a general idea of whether to proceed with a project in terms of its profitability, there are several limitations to this approach:
It ignores the time value of money. It assumes accounting income in future years has the same value as accounting income in the current year. A better metric that considers the present value of all future cash flows is NPV and Internal Rate of Return (IRR).
It does not consider the increased risk of long-term projects and the increased variability associated with prolonged projects.
It is only a financial guide for projects. Sometimes projects are proposed and implemented to enhance other important variables such as safety, environmental concerns, or governmental regulations.
It is not an ideal comparative metric between projects because different projects have different variables such as time and other non-financial factors to consider.
We hope the above article has been a helpful guide to understanding the Accounting Rate of Return, the formula, and how you can use it in your career. To keep learning and advancing your career these additional CFI resources will be helpful:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.
In order to become a great financial analyst, here are some more questions and answers for you to discover:
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