Accounting rate of return is the estimated accounting profit that the company makes from investment or the assets. It is the percentage of average annual profit over the initial investment cost. This method is very useful for project evaluation and decision making while the fund is limited. The company needs to decide whether or not to make a new investment such as purchasing an asset by comparing its cost and profit.The company may accept a new investment if its ARR higher than a certain level, usually known as the hurdle rate which already approved by top management and shareholders. It aims to ensure that new projects will increase shareholders’ wealth for sustainable growth.
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Accounting Rate of Return Formula
Average Annual Profit is the total annual profit of the projects divided by the project terms, it is allowed to deduct the depreciation expense.
Example: ARR for single projectCompany A is considering investing in a new project which costs $ 500,000 and they expect to make a profit of $ 100,000 per year for 5 years.ARR = 100,000 / 500,000 = 20%
Example: ARR of new equipmentCompany ABC is planning to purchase new production equipment which cost $ 10M. The company expects to increase the revenue of $ 3M per year from this equipment, it also increases the operating expense of around $ 500,000 per year (exclude depreciation). The machinery has 10 years of useful life with zero scrap value.
Please calculate the ARR.Depreciation pe year = $ 10M / 10 year = $ 1MAnnual profit = ($ 3M –$ 0.5M –$ 1M) = $ 1.5MARR = 1.5 / 10 = 15%
Example: simple rate of return method with salvage valueCompany P is considering to purchase new production equipment with the detail as below;Cost of this equipment is $ 800,000It expects to use for 5 years with scrape value of 50,000 at the end of year 5The company expect to generate sale of 300,000 per year from it, however, it will require the maintaining cost of $ 30,000 per yearPlease calculate the ARR.Depreciation = ($ 800,000 – $ 30,000)/5year = $ 154,000 per yearAverage annual profit = ($ 300,000 – $ 30,000 – $ 154,000) = $ 116,000ARR = $ 116,000/$ 800,000 = 14.50 %
Accounting Rate of Return in ExcelWe can use Excel to help us in calculating ARR as following:
What are the Advantages of Accounting Rate of Return?
What are the Disadvantages of Accounting Rate of Return?
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