Accounting Rate of Return Calculation

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Accounting Rate of Return Calculator

function calculateARR() { var initialInvestment = parseFloat(document.getElementById("initialInvestment").value); var annualRevenue = parseFloat(document.getElementById("annualRevenue").value); var annualExpenses = parseFloat(document.getElementById("annualExpenses").value); var projectedLifespan = parseFloat(document.getElementById("projectedLifespan").value); var resultDiv = document.getElementById("result"); resultDiv.innerHTML = ""; // Clear previous results if (isNaN(initialInvestment) || isNaN(annualRevenue) || isNaN(annualExpenses) || isNaN(projectedLifespan) || initialInvestment < 0 || annualRevenue < 0 || annualExpenses < 0 || projectedLifespan <= 0) { resultDiv.innerHTML = "Please enter valid positive numbers for all fields. Projected lifespan must be greater than zero."; return; } // Calculate Average Annual Profit var averageAnnualProfit = annualRevenue – annualExpenses; // Calculate Average Investment Value (Assuming straight-line depreciation for simplicity) // For a more complex calculation, salvage value would be needed. // Here, we use (Initial Investment) / 2 as a common simplified approach for average book value. var averageInvestment = initialInvestment / 2; // Calculate Accounting Rate of Return (ARR) var arr = (averageAnnualProfit / averageInvestment) * 100; resultDiv.innerHTML = "Average Annual Profit: $" + averageAnnualProfit.toFixed(2) + "" + "Average Investment: $" + averageInvestment.toFixed(2) + "" + "Accounting Rate of Return (ARR): " + arr.toFixed(2) + "%"; }

Understanding the Accounting Rate of Return (ARR)

The Accounting Rate of Return (ARR), also known as the Average Rate of Return, is a profitability metric used in capital budgeting and investment appraisal. It measures the anticipated profit or return generated by an investment project relative to the initial cost of that investment.

How ARR is Calculated

The ARR is calculated using a straightforward formula:

ARR = (Average Annual Profit / Average Investment) * 100

Let's break down the components:

  • Average Annual Profit: This is calculated by taking the total expected revenue from the project over its lifespan and subtracting the total expected expenses, then dividing by the number of years the project is expected to last. In this calculator, we simplify this by taking the provided Average Annual Revenue and subtracting the Average Annual Expenses.
  • Average Investment: This represents the average book value of the asset or project over its life. A common simplification, used in this calculator, is to take the Initial Investment Cost and divide it by two, assuming a straight-line depreciation where the asset's value decreases evenly over time to zero (or a salvage value, which is not included in this basic calculation).

Interpreting the ARR

The ARR is expressed as a percentage. A higher ARR generally indicates a more profitable investment. Businesses often compare the calculated ARR to a target rate of return or hurdle rate. If the project's ARR meets or exceeds this target, it may be considered acceptable.

Advantages of ARR:

  • Simple to calculate and understand.
  • Uses accounting profits, which are readily available from financial statements.
  • Considers the entire expected life of the project.

Limitations of ARR:

  • Ignores the time value of money (it treats cash flows received in different years as having equal value).
  • Relies on accounting profits, which can be manipulated through different accounting methods.
  • Does not consider the cash flows directly, only profits.
  • The method for calculating average investment can vary, leading to different results.

Example Calculation

Suppose a company is considering a new project with the following details:

  • Initial Investment Cost: $50,000
  • Average Annual Revenue: $15,000
  • Average Annual Expenses: $5,000
  • Projected Lifespan: 5 Years

Using our calculator:

  1. Average Annual Profit: $15,000 (Revenue) – $5,000 (Expenses) = $10,000
  2. Average Investment: $50,000 (Initial Cost) / 2 = $25,000
  3. ARR: ($10,000 / $25,000) * 100 = 40%

Therefore, the Accounting Rate of Return for this project is 40%. The company would then compare this 40% to their internal hurdle rate to decide if the project is worthwhile.

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