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This accounting rate of return template will demonstrate two examples of ARR calculations.
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Accounting Rate of Return (ARR) is the average net income an asset is expected to generate divided by its average capital cost and expressed as an annual percentage. The ARR is a formula used to make capital budgeting decisions. These typically include situations where companies are deciding on whether or not to proceed with a specific investment (a project, an acquisition, etc.) based on the future net earnings expected, compared to the capital cost.
The formula for ARR is: ARR = average annual profit / average investment
Average investment = (book value at year 1+ book value at end of useful life) / 2
Average annual profit = total profit over investment period/number of years
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 the 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 investment.
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