ARR

Definition

ARR, or Accounting Rate of Return, is a non-time value-based capital investment decision-making method that evaluates the profitability of a project by comparing the average annual accounting profit generated by the investment to the average investment amount. It provides a straightforward way to assess the relative profitability of different investment options.

5 Must Know Facts For Your Next Test

1. ARR is calculated as the average annual accounting profit divided by the average investment amount.
2. ARR does not consider the time value of money, unlike time value-based methods such as NPV and IRR.
3. ARR is easy to calculate and understand, making it a popular method for quick investment comparisons.
4. ARR does not account for the project's entire lifespan or the timing of cash flows, which can lead to inaccurate assessments.
5. ARR is often used as a supplementary method alongside time value-based techniques to provide a more comprehensive evaluation of investment decisions.

Review Questions

• Explain how the Accounting Rate of Return (ARR) is calculated and what it represents.
  • The Accounting Rate of Return (ARR) is calculated by dividing the average annual accounting profit generated by an investment by the average investment amount. The result represents the average annual return on the investment as a percentage, providing a straightforward way to assess the relative profitability of different investment options. Unlike time value-based methods, ARR does not consider the time value of money or the timing of cash flows, making it a simpler but potentially less accurate approach to capital investment decision-making.
• Compare and contrast the Accounting Rate of Return (ARR) with time value-based methods, such as Net Present Value (NPV) and Internal Rate of Return (IRR).
  • The key difference between ARR and time value-based methods like NPV and IRR is that ARR does not consider the time value of money. ARR focuses solely on the average annual accounting profit and average investment amount, whereas NPV and IRR discount future cash flows to their present value, taking into account the timing and riskiness of the cash flows. This makes time value-based methods more comprehensive in evaluating the true financial viability of an investment, but also more complex to calculate. ARR, on the other hand, is a simpler and more intuitive approach, but it may not accurately capture the full financial implications of a project, particularly for long-term investments with uneven cash flow patterns.
• Discuss the role of Accounting Rate of Return (ARR) in the context of capital investment decisions, and explain when it may be an appropriate or limited method to use.
  • The Accounting Rate of Return (ARR) can be a useful tool in the capital investment decision-making process, particularly when making quick, high-level comparisons between investment options. Its simplicity and ease of calculation make it an attractive method for quickly assessing the relative profitability of different projects. However, ARR's limitations in not considering the time value of money and the timing of cash flows mean that it should be used with caution, especially for long-term or complex investments. In such cases, time value-based methods like NPV and IRR are generally more appropriate for a comprehensive evaluation, as they provide a more accurate assessment of the project's financial viability. Ultimately, the choice of using ARR or time value-based methods (or a combination of both) will depend on the specific investment decision, the available data, and the desired level of financial analysis.

Related terms

Payback Period: The Payback Period is another non-time value-based method that calculates the number of years required to recover the initial investment from the project's cash inflows.

Net Present Value (NPV): NPV is a time value-based method that discounts all future cash flows back to their present value to determine whether a project is financially viable.

Internal Rate of Return (IRR): IRR is a time value-based method that calculates the discount rate that makes the net present value of all cash flows from a project equal to zero.