Complete Guide To Corporate Finance

AAA

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. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  2. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  3. Professionals

    Is A Stockbroker Career For You?

    Becoming a stockbroker requires a broad skill set and the willingness to put in long hours. But the rewards can be enormous.
  4. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  5. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  9. Professionals

    A Day In The Life Of A Public Accountant

    Here's an inside look at the workdays of two experienced CPAs, to give you an idea of what it might be like to pursue a career as a public accountant.
  10. Professionals

    A Day in the Life of a Public Accountant

    There’s no typical day in the life of a public accountant, but one accountant’s experience may shed some light on what the career entails.
RELATED TERMS
  1. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
  2. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  3. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  4. Audit

    An unbiased examination and evaluation of the financial statements ...
  5. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  6. Climate Finance

    Climate finance is a finance channel by which developed economies ...
RELATED FAQS
  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. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  6. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center