Complete Guide To Corporate Finance


Net Present Value And Internal Rate Of Return - Average Accounting Return

Average accounting return, also called accounting rate of return or ARR, is an accounting method used for the purposes of comparison with other capital budgeting calculations, such as NPV, PB period and IRR.

ARR provides a quick estimate of a project's worth over its useful life. ARR is calculated by finding a capital investment's average operating profits before interest and taxes but after depreciation and amortization (also known as "EBIT") and dividing that number by the book value of the average amount invested. It can be expressed as the following:

ARR = Average Profit / Average Investment

The result is expressed as a percentage. In other words, ARR compares the amount invested to the profits earned over the course of a project's life. The higher the ARR, the better.

The major drawbacks of ARR are as follows:

1. It uses operating profit rather than cash flows. Some capital investments have high upkeep and maintenance costs, which bring down profit levels. 2. Unlike NPV and IRR, it does not account for the time value of money. By ignoring the time value of money, the capital investment under consideration will appear to have a higher level of return than what will occur in reality. The capital investment may appear to be more lucrative than the alternatives, such as investing in the financial markets, when it is actually less lucrative.

Here is a simple example of an ARR calculation: A project requiring an average investment of $1,000,000 and generating an average annual profit of $150,000 would have an ARR of 15%.

While ARR is easy to calculate and can be used to gauge the results of other capital budgeting calculations, it is not the most accurate metric.

Internal Rate Of Return
Related Articles
  1. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  2. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  3. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  4. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  5. Professionals

    Career Advice: Accountant Vs. Controller

    Learn about the differences between controllers and accountants, how the two are related and which is the best career choice for aspiring bookkeepers.
  6. Professionals

    What is Cash Basis Accounting?

    Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.
  7. Entrepreneurship

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  8. Fundamental Analysis

    Emerging Markets: Analyzing Chile's GDP

    Chile has become one of the great economic success stories of Latin America.
  9. Investing

    Watch Your Duration When Rates Rise

    While recent market volatility is leading investors to look for the nearest exit, here are some suggestions for bond exposure in attractive sectors.
  10. Economics

    Understanding Explicit Costs

    Common examples of explicit costs include wages, utilities, rent, raw materials, and other direct expenses companies pay to conduct business.
  1. Put-Call Parity

    A principle that defines the relationship between the price of ...
  2. Encumbrance

    A claim against a property by a party that is not the owner. ...
  3. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Linear Relationship

    A statistical term used to describe the directly proportional ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. Student loans, federal and private: what's the difference?

    The cost of a college education now rivals many home prices, making student loans a huge debt that many young people face ... Read Full Answer >>
  6. What is a profit and loss (P&L) statement and why do companies publish them?

    A profit and loss (P&L) statement, or balance sheet, is essentially a snapshot of a company's financial activity for ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!