Complete Guide To Corporate Finance

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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

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