Knowing how to calculate accounting return on investment (ARR) is important in capital planning as it is used to determine the adequacy of a particular investment. If the response for ARR exceeds a certain rate accepted by the company, the project will be selected.
Formula for calculating the discount rate (ARR)
ARR can be calculated using the following formula:
The average book profit is the mean value of the book profit that is expected to be achieved within the project duration. Instead of the initial investment, there are cases where the average investment is used.
The decision to accept or reject a project is based on the value generated in RR. The project is accepted if the ARR value is equal to or greater than the required rate of return. For mutually exclusive projects, the project that generates the higher ARR is accepted.
Examples of calculating the return on investment (ARR)
The following examples illustrate the methods used to calculate the ARI.
Example 1: Project A has an initial investment of $ 150,000 and expects an annual inflow of $ 40,000 over 5 years. The straight-line method is used for depreciation. The scrap value at the end of the 5th year is approximately $ 20,000. ARR can be calculated as,
Example 2: Compare the following mutually exclusive projects based on the FER and identify which project is financially feasible.
Since the ARR of project A is higher than that of B, it is cheaper than that of project B.
There are many advantages and disadvantages of ARR as stated below:
Advantages of the ARR calculation
- It is almost similar to the payback period and this method of investment valuation is easy to calculate.
- It helps identify the return on investment factor.
Disadvantages of the ARR calculation
- It avoids the time value of money. When the ARR is used to compare two projects with the same initial investment, the project that generates higher annual income in the later stages will rank higher regardless of the initial income.
- This calculation can be processed in many ways, but in some cases there are consistency problems.
- It uses the accounting revenues that are not related to the cash flows. However, it is not suitable for projects that have higher maintenance costs as profitability is heavily dependent on cash flow.