The Accounting Rate of Return (ARR), also known as the Average Rate of Return, is a profitability metric used in capital budgeting to estimate the return on an investment. It measures the average profit an asset is expected to generate over its useful life as a percentage of the initial investment. ARR is a simple way to assess whether a project or investment is likely to be profitable.
How is the Accounting Rate of Return Calculated?
The formula for calculating the Accounting Rate of Return is:
ARR = (Average Annual Net Income / Initial Investment) * 100
Where:
Initial Investment: This is the total cost incurred to acquire the asset or start the project. It includes all relevant expenses such as the purchase price, installation costs, and any setup fees.
Average Annual Net Income: This represents the expected net profit generated by the investment each year, after accounting for all operating expenses and depreciation, but before considering financing costs. To calculate this, you would typically sum up the net income for each year of the project's life and divide by the number of years.
Interpreting the ARR:
A higher ARR generally indicates a more attractive investment. Companies often set a minimum acceptable ARR hurdle rate. If a project's ARR is above this threshold, it may be considered for approval. However, ARR does not consider the time value of money, which is a significant limitation compared to other investment appraisal techniques like Net Present Value (NPV) or Internal Rate of Return (IRR).
Example:
Let's say a company is considering investing $100,000 in a new piece of machinery. This machinery is expected to generate an average annual net income of $20,000 over its useful life. Using the ARR formula:
ARR = ($20,000 / $100,000) * 100 = 20%
This means the investment is expected to yield an accounting rate of return of 20% per year.
function calculateARR() {
var initialInvestment = parseFloat(document.getElementById("initialInvestment").value);
var annualNetIncome = parseFloat(document.getElementById("annualNetIncome").value);
var resultDiv = document.getElementById("result");
if (isNaN(initialInvestment) || initialInvestment <= 0) {
resultDiv.innerHTML = "Please enter a valid positive number for the Initial Investment.";
return;
}
if (isNaN(annualNetIncome)) {
resultDiv.innerHTML = "Please enter a valid number for the Average Annual Net Income.";
return;
}
var arr = (annualNetIncome / initialInvestment) * 100;
resultDiv.innerHTML = "The Accounting Rate of Return (ARR) is: " + arr.toFixed(2) + "%";
}
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