What is the Accounting Rate of Return (ARR)?
The Accounting Rate of Return (ARR), also known as the Average Rate of Return, is a financial metric used to evaluate the profitability of an investment or project. It measures the average annual profit an investment is expected to generate as a percentage of the initial investment cost. Unlike cash flow based methods, ARR uses accounting profits, which include non-cash expenses like depreciation, but it's a straightforward method for initial investment appraisal.
How to Calculate ARR:
The formula for ARR is:
ARR = (Average Annual Profit / Initial Investment Cost) * 100%
Where:
- Average Annual Profit: This is typically calculated by taking the total net profit over the project's lifespan and dividing it by the number of years in the project's lifespan. Alternatively, if depreciation is considered, it's often calculated as (Average Annual Revenue – Average Annual Operating Expenses – Average Annual Depreciation). For simplicity in this calculator, we use the 'Average Annual Net Cash Flow' as a proxy for average annual profit, assuming it accounts for all relevant costs before depreciation. A more precise calculation would require separate revenue, expense, and depreciation figures.
- Initial Investment Cost: This is the total upfront cost required to undertake the investment or project.
Interpreting the Result:
A higher ARR generally indicates a more profitable investment. Businesses often set a minimum acceptable ARR as a benchmark. If an investment's ARR exceeds this benchmark, it may be considered for acceptance. However, ARR does not consider the time value of money, so it should be used in conjunction with other investment appraisal techniques like Net Present Value (NPV) or Internal Rate of Return (IRR) for a more comprehensive analysis.
Example Calculation:
Let's say a company is considering a new project with the following details:
- Initial Investment Cost: $50,000
- Average Annual Net Cash Flow (assumed to represent profit): $15,000
- Projected Lifespan: 5 years
Using the calculator:
- Initial Investment Cost = 50000
- Average Annual Net Cash Flow = 15000
Calculation:
ARR = ($15,000 / $50,000) * 100% = 0.30 * 100% = 30%
This means the project is expected to generate an accounting rate of return of 30% on the initial investment.
function calculateArr() {
var initialInvestment = parseFloat(document.getElementById("initialInvestment").value);
var annualNetCashFlow = parseFloat(document.getElementById("annualNetCashFlow").value);
var projectedLifespan = parseFloat(document.getElementById("projectedLifespan").value); // Although not directly used in the simplified ARR formula here, it's relevant context for average annual profit.
var resultElement = document.getElementById("result");
resultElement.innerHTML = ""; // Clear previous results
if (isNaN(initialInvestment) || isNaN(annualNetCashFlow) || isNaN(projectedLifespan)) {
resultElement.innerHTML = "Please enter valid numbers for all fields.";
return;
}
if (initialInvestment <= 0) {
resultElement.innerHTML = "Initial Investment Cost must be greater than zero.";
return;
}
if (projectedLifespan <= 0) {
resultElement.innerHTML = "Projected Lifespan must be greater than zero.";
return;
}
// Simplified ARR calculation using average annual net cash flow as average annual profit
var arr = (annualNetCashFlow / initialInvestment) * 100;
resultElement.innerHTML = "
Result:
" +
"The Accounting Rate of Return (ARR) is:
" + arr.toFixed(2) + "%";
}
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