Financial Management Research

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Accounting Rate Return (ARR)

* Is the amount of profit, or return, that an individual can expect based on an investment made. Accounting rate of return divides the average profit by the initial investment in order to get the ratio or return that can be expected. This allows an investor or business owner to easily compare the profit potential for projects, products and investments. 

* Is the ratio of the estimated accounting profit of a project to its average investment. It is an investment appraisal technique. ARR ignores the time value of money.

* Accounting rate of return, also known as the Average rate of return. or ARR is a financial ratio used in capital budgeting.  The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

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. It is rarely used by investors, and should not be used at all, because:

* Cash flows are more important to investors, and ARR is based on numbers that include non-cash items.

* 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.

* It does not adjust for the greater risk to longer term forecasts.

* There are better alternatives which are not significantly more difficult to calculate.

The accounting rate of...
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