What Is Accounting Rate of Return (ARR)?

What Is Accounting Rate of Return (ARR)?

Let me explain the accounting rate of return, or ARR, directly to you. It's a capital budgeting metric that helps calculate the profitability of an investment. As someone evaluating projects, you can use ARR to compare multiple options and determine the expected rate of return for each, aiding decisions on investments or acquisitions.

The formula for ARR divides the asset's average revenue by the initial investment, giving you a ratio or return based on the net income from the proposed capital investment. Remember, ARR focuses on the average annual profit divided by the initial outlay, making it a tool for project comparison, but it differs from the required rate of return (RRR), which is the minimum return you'd accept to offset risk.

Calculating ARR

To calculate ARR, start by figuring the annual net profit from the investment—that's revenue minus any annual costs or expenses involved in the project. If you're dealing with a fixed asset like property, plant, or equipment, subtract depreciation from the annual revenue to get that net profit.

Then, divide that annual net profit by the initial cost of the asset or investment. You'll get a decimal, which you multiply by 100 to express as a percentage return. The formula is straightforward: ARR equals average annual profit divided by initial investment.

Example

Consider this example to see ARR in action. Suppose a business is looking at a project with an initial investment of $250,000, and it expects to generate $70,000 in revenue each year for five years. You calculate ARR by dividing $70,000 by $250,000, which gives 0.28, or 28%. That's the expected return rate.

Pros and Cons

ARR has its advantages, as it's a simple calculation without complex math, letting you compare it directly to your desired minimum return. For instance, if a project needs at least 12% return and ARR comes in at 9%, you know to pass on it.

On the downside, ARR ignores the time value of money and cash flows, meaning it doesn't value quicker returns higher or account for the risks in long-term projects. It also overlooks the timing of cash inflows, which can make it less reliable for comprehensive evaluations.

ARR vs. RRR

Understand that ARR is the annual percentage return based on initial outlay, while the required rate of return (RRR), or hurdle rate, is the minimum you'd accept to compensate for risk. RRR uses models like dividend discount or capital asset pricing to factor in market comparisons and varies by your risk tolerance—as a risk-averse investor, you'd demand a higher RRR. You might use both ARR and RRR together to assess if an investment fits your risk profile.

Frequently Asked Questions

You might wonder how depreciation affects ARR—it reduces it, as depreciation is a cost that lowers the asset's value or company profit, cutting into the return. When choosing projects, the rule is to pick the one with the highest ARR, provided it's at least your cost of capital.

Compared to internal rate of return (IRR), ARR is non-discounted and skips the time value of money, while IRR discounts future cash flows for a more precise present value assessment.

The Bottom Line

In summary, ARR is a simple formula for you to gauge asset or project profitability, useful for comparing options due to its ease. However, it doesn't factor in cash flows or return timelines, so consider those for a full picture of an investment's value.