Accounting Rate of Return (ARR) (Cambridge International A-Level Accounting)

Spec point — how to apply the following capital investment appraisal techniques: – accounting rate of return (ARR = (average profit / average investment) × 100) the advantages and disadvantages of these capital investment appraisal techniques

Accounting rate of return (ARR)

What is the accounting rate of return (ARR)?

• The accounting rate of return measures the average annual profit as a percentage of the average investment
• It is the only investment appraisal method that uses profit, not cash flows
• Owners usually prefer investments which have a higher accounting rate of return
• If the accounting rate of return is higher than the target rate, then the project is usually accepted
• If the accounting rate of return is lower than the target rate, then the project is usually rejected

How do I calculate the accounting rate of return?

• STEP 1 Calculate the net cash flow for each year

• STEP 2 Calculate the average profit

  • Add together the net cash flows including Year 0

    • Including Year 0 makes sure the depreciation is subtracted from the cash flows
    • The residual value in your exam will always be zero, and therefore, the total depreciation is equal to the initial investment

  • Divide by the number of years

    • Don't count Year 0

• STEP 3 Calculate the average investment

  • The residual value will always be zero in your exam

  • Therefore, the average investment is equal to half the initial cost

    • $\mathrm{Average} \mathrm{investment}=\frac{\mathrm{Initial} \mathrm{cost}}{2}$

• STEP 4 Calculate the accounting rate of return

  • $\mathrm{ARR}=\frac{\mathrm{Average} \mathrm{profit}}{\mathrm{Average} \mathrm{investment}}\times100$

    • Write as a percentage

Exam Hint Some students confuse the ARR with the IRR. Remember the ARR formula using averages.

What are the advantages and disadvantages of the accounting rate of return method?

Advantages

• It uses profit

  • This makes it easy to compare with ROCE targets
  • Managers are familiar with working with the profit

• It is expressed as a percentage

  • This makes it easy to compare with target rate

• It considers all years of the project

Disadvantages

• It ignores the time value of money

• It uses the average profit

  • This can be misleading

• It ignores timing of cash flows

Worked Example The directors of D plc are considering the purchase of a new machine, costing $220 000, to manufacture a newly developed product, Product Omega. The directors intend to manufacture the product for only four years, after which the machine will have zero residual value.

The machine is to be depreciated over its life with no residual value, using the straight-line method.

The directors have estimated the following net cash flows arising from the project:

Year	Net cash flow ($)
1	45 000
2	60 000
3	105 000
4	30 000

Calculate the accounting rate of return (ARR) to two decimal places.

Answer:

Calculate the average profit

• Add together the net cash flows including Year 0

Year	Net cash flow ($)
0	(220 000)
1	45 000
2	60 000
3	105 000
4	30 000
	20 000

• Divide by the number of years

\text{Average} \text{profit} = \frac{\ 20 000}{4} = $ 5 000$

Calculate the average investment

• Divide the initial cost by 2

\text{Average} \text{investment} = \frac{\ 220 000}{2} = $ 110 000$

Calculate the ARR

$\frac{5000}{110000}\times100=4.545...$

Round to 2 decimal places

Final answer: ARR = 4.55%