ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest. ARR is an accounting method used for purposes of comparison. The major drawbacks of ARR are that it uses profit rather than cash flows, and it does not account for the time value of money.
ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organisation. Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out.
How to calculate ARR
The Accounting rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation.
Accounting Rate of Return (ARR) = Average income / Average investment Average rate of Return= Estimated average annual income
Average investment is original investment divided by 2
Advantage of ARR
1) Easy to calculate
2) Fairly easy to construct (realistic) examples
Disadvantage of ARR
1) Cash flows are more important to investors, and ARR is based on numbers that include non-cash items. 2) ARR does not take into account the time value of money — the value of cash flows does not diminish with time as is the case with NPV and IRR. 3) It does not adjust for the greater risk to longer term forecasts. 4) There are better alternatives which are not significantly more difficult to calculate.
Average annual net income = ($225,000 + $225,000 + $225,000)/3 = $225,000
Average investment = ($600,000 + $0)/2
Average accounting return = $225,000/$300,000...