The accounting rate of return, or ARR, is another method of investment appraisal. It is found by calculating the average accounting profit as a percentage of the average investment. To find the average investment, just divide the initial outlay by 2. If the asset depreciates and you’re using the straight-line method of depreciation, use this formula to calculate the average investment:
(Initial investment + Scrap value)/2
Let’s take an example. Say you know the following details about a particular project:
- Number of years that the project is going to be used for: 5
- Average annual profit over the 5 years: $50,000
- Initial investment: $100,000
- Scrap value: $30,000
- Average investment: $65,000
The accounting rate of return of an investment in this asset is 77%.
There are 2 main advantages of using this method of investment appraisal. The first is that it is relatively easy to calculate (at least, compared to other methods such as internal rate of return). It also allows you to easily compare the profitability of the business at present as both figures would be expressed in the form of a percentage. Moreover, the formula considers the earnings across the entire lifetime of the project, rather than only considering the net inflows only before the cost of investment is recovered (like in the payback period).
On the other hand, there are some disadvantages of using this method. First of all, it doesn’t consider the time value of money either, like the payback period. The time value of money refers to the future value of a particular amount of money. For example, the value of $10 today is going to fall in the future as a result of inflation. This means that the figures for cash inflows and outflows, and therefore the accounting rate of return figure, are not accurate.