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

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  2. Investing

    How to calculate your investment return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  3. Small Business

    How to Calculate NPV Using XNPV Function in Excel

    Learn how to calculate the net present value (NPV) of your investment projects using built-in functions from Excel using the XNPV function.
  4. Small Business

    Calculating IRR with Excel

    Find out how to calculate the internal rate of return on investments using Microsoft Excel, as illustrated in different investment scenarios.
  5. Investing

    Return on investment versus internal rate of return

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  6. Investing

    Capital Budgeting

    Learn the process through which businesses determine whether projects are worth pursuing.
  7. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
Trading Center