The accounting rate of return is measured as follows
Chapter Contents:. Capital projects involve the acquisition of assets that generate returns over multiple periods. Examples are the construction of a factory or the purchase of a new machine. In this context, a dollar saved is as good as a dollar earned.
Accounting Rate of Return | ARR | AAR | ROI
Many companies are presented with investment opportunities continuously and must sift through both viable and nonviable options to identify the best possible expenditure for business growth.
The process to select the best option requires careful budgeting and analysis. In conducting their analysis, a company may use various evaluation methods with differing inputs and analysis features. We will examine the non-time value methods first.
Non-time value methods do not compare the value of a dollar today to the value of a dollar in the future and are often used as screening tools. Two non-time value evaluative methods are the payback method and the accounting rate of return. The payback method PM computes the length of time it takes a company to recover their initial investment. In other words, it calculates how long it will take until either the amount earned or the costs saved are equal to or greater than the costs of the project.
This can be useful when a company is focused solely on retrieving their funds from a project investment as quickly as possible. Businesses do not want their money tied up in capital assets that have limited liquidity. The longer money is unavailable, the less ability the company has to use these funds for other growth purposes. This extended length of time is also a concern because it produces a riskier opportunity. Therefore, a company would like to get their money returned to them as quickly as possible.
One way to focus on this is to consider the payback period when making a capital budget decision. The payback period is calculated when there are even or uneven annual cash flows. Cash flow is money coming into or out of the company as a result of a business activity. A cash inflow can be money received or cost savings from a capital investment. A cash outflow can be money paid or increased cost expenditures from capital investment.
Cash flow will estimate the ability of the company to pay long-term debt, its liquidity, and its ability to grow. Cash flows appear on the statement of cash flows. Cash flows are different than net income. Net income will represent all company activities affecting revenues and expenses regardless of the occurrence of a cash transaction and will appear on the income statement.
A company will estimate the future cash inflows and outflows to be generated by the capital investment. Cash flow can also be generated through increased production volume. The difference between cash inflows and cash outflows is the net cash inflow or outflow, depending on which cash flow is larger.
Annual net cash flows are then related to the initial investment to determine a payback period in years. When the expected net annual cash flow is an even amount each period, payback can be computed as follows:. The result is the number of years it will take to recover the cash made in the original investment.
The payback period is. For example, the company might require a payback period of 5 years. Since 7. If the company required a payback period of 9 years, the company would consider moving this alternative to a preference decision, since the number of years is less than the requirement. When net annual cash flows are uneven over the years, as opposed to even as in the previous example, the company requires a more detailed calculation to determine payback.
Uneven cash flows occur when different amounts are returned each year. However, in most examples, organizations experience uneven cash flows in a multiple-year ownership period. In a second example of the payback period for uneven cash flows, consider a company that will need to determine the net cash flow for each period and figure out the point at which cash flows equal or exceed the initial investment.
This could arise in the middle of a year, prompting a calculation to determine the partial year payback. We know that somewhere between years 5 and 6, the company recovers the money. This is more than they needed to recoup their initial investment. For illustration, consider Baby Goods Manufacturing BGM , a large manufacturing company specializing in the production of various baby products sold to retailers.
BGM is considering investment in a new metal press machine. The payback period is calculated as follows:. Assume that BGM will not allow a payback period of more than 7 years for this type of investment. Since this computed payback period meets their initial screening requirement, they can pass this investment opportunity on to a preference decision level. If BGM had an expected or maximum allowable payback period of 2 years, the same investment would not have passed their screening requirement and would be dropped from consideration.
Between years 6 and 7, the initial investment outstanding balance is recovered. To determine the more specific payback period, we calculate the partial year payback. You are the accountant at a large firm looking to make a capital investment in a future project. Your company is considering two project investments.
Your company requires a payback period of no more than 5 years on such projects. Which project should they further consider? Is there an argument that can be made to advance either project or neither project? What other factors might be necessary to make that decision? The accounting rate of return ARR computes the return on investment considering changes to net income. It shows how much extra income the company could expect if it undertakes the proposed project.
Unlike the payback method, ARR compares income to the initial investment rather than cash flows. This method is useful because it reviews revenues, cost savings, and expenses associated with the investment and, in some cases, can provide a more complete picture of the impact, rather than focusing solely on the cash flows produced. However, ARR is limited in that it does not consider the value of money over time, similar to the payback method.
Incremental revenues represent the increase to revenue if the investment is made, as opposed to if the investment is rejected. The increase to revenues includes any cost savings that occur because of the project.
Incremental expenses show the change to expenses if the project is accepted as opposed to maintaining the current conditions. Incremental expenses also include depreciation of the acquired asset. The difference between incremental revenues and incremental expenses is called the incremental net income.
The initial investment is the original amount invested in the project; however, any salvage residual value for the capital asset needs to be subtracted from the initial investment before obtaining ARR. The concept of salvage value was addressed in Long-Term Assets. Basically, it is the anticipated future fair market value FMV of an asset when it is to be sold or used as a trade-in for a replacement asset. There is one more point to make with this example. The fair market value is not the same as the book value.
The book value is the original cost less the accumulated depreciation that has been taken. The fair market value could be more, less, or the same as the book value. For example, a piano manufacturer is considering investment in a new tuning machine. ARR is computed as:. The company will have a minimum expected return that this project will need to meet or exceed before further consideration is given. ARR, like payback method, should not be used as the sole determining factor to invest in a capital asset.
Also, note that the ARR calculation does not consider uneven annual income growth, or other depreciation methods besides straight-line depreciation. Returning to the BGM example, the company is still considering the metal press machine because it passed the payback period method of less than 7 years.
A hurdle rate is the minimum required rate of return on an investment to consider an alternative for further evaluation. In this case, BGM would move this investment option to a preference decision level. In both cases, the project ARR would be less than the required rate, so BGM would not further consider either investment. There is no salvage value for the printer. What is the accounting rate of return ARR for this printer?
Both the payback period and the accounting rate of return are useful analytical tools in certain situations, particularly when used in conjunction with other evaluative techniques. In certain situations, the non-time value methods can provide relevant and useful information. However, when considering projects with long lives and significant costs to initiate, there are more advanced models that can be used.
These models are typically based on time value of money principles, the basics of which are explained here. Figure What is the payback method used to determine? It is used to determine the length of time needed for a long-term project to recapture or pay back the initial investment in the project.
Figure What are one advantage and one disadvantage of the payback method? Figure What are one advantage and one disadvantage of the accounting rate of return method? Advantage: The ARR compares income to the initial investment rather than to cash flows; thus, incremental revenues, cost savings, and incremental expenses associated with the investment are reviewed and provide a more complete picture than payback, which uses cash flows.
Disadvantage: ARR is limited in that it does not consider the value of a dollar over time. Figure What is the equation to calculate the payback period? Figure What is the equation to calculate the accounting rate of return? Which of the two options would you choose based on the payback method? Figure The management of Kawneer North America is considering investing in a new facility and the following cash flows are expected to result from the investment:.
There is no salvage value. What is the accounting rate of return ARR? What is the payback period? Figure The management of Ryland International is considering investing in a new facility and the following cash flows are expected to result from the investment:.
Question 1. The accounting rate of return is measured as follows: a) Average annual profit expressed as a percentage of the total funds invested in the project. The accounting rate of return (ARR) measures the amount of profit, or return, expected on investment as compared with the initial cost.
Many companies are presented with investment opportunities continuously and must sift through both viable and nonviable options to identify the best possible expenditure for business growth. The process to select the best option requires careful budgeting and analysis. In conducting their analysis, a company may use various evaluation methods with differing inputs and analysis features.
The accounting rate of return ARR is the percentage rate of return expected on investment or asset as compared to the initial investment cost. ARR divides the average revenue from an asset by the company's initial investment to derive the ratio or return that can be expected over the lifetime of the asset or related project.
The examiner's style is to test this area of the syllabus as partof a much larger question. Usually, a part c , or part d , you willhave to discuss or explain some of the key aspects and theirimplications.
Accounting Rate of Return – ARR Definition
Accounting Rate of Return , shortly referred to as ARR , is the percentage of average accounting profit earned from an investment in comparison with the average accounting value of investment over the period. ARR may be compared with the target return on investment. Investments may be accepted if the ARR exceeds the target return. The calculation of ARR requires finding the average profit and average book values over the investment period. Whereas average profit is fairly simple to calculate, there are several ways to calculate the average book value of investment. How should average book value be calculated?
Chapter 20: Questions & Answers
The cash inflows and outflows associated with a project are as follows: The payback period for this project would be:. What would be the accounting rate of return for this project? Macchu Ltd is about to undertake a project and has computed the NPV of the project using a variety of discount rates: What is the approximate IRR of this project? Bond Ltd is considering two possible projects but can only raise enough funds to proceed with one of them. Investment appraisal techniques have been used and the following results found: Which of the following is the most logical interpretation of the results? Assume the cash flows arise at the end of each year. Instructions Answer the following questions and then press 'Submit' to get your score. Question 1 The accounting rate of return is measured as follows: a Average annual profit expressed as a percentage of the total funds invested in the project. Question 2 The cash inflows and outflows associated with a project are as follows: The payback period for this project would be: a 2 years and 3 months.
Accounting rate of return also known as simple rate of return is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.
