Accounting Rate of Return & Average Rate of Return Explained.

In this video, we explain accounting rate of return & average rate of return.
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Accounting Rate of Return (ARR) & Average Rate of Return
The Accounting Rate of Return (ARR), also known as the Average Rate of Return, is a financial metric used to evaluate the profitability of an investment. It measures the percentage return generated relative to the investment’s initial cost or average investment value.
What is ARR?
ARR assesses a project's financial performance by comparing the average annual accounting profit to the investment. It is a simple and straightforward measure often used in capital budgeting decisions. Unlike other methods like NPV or IRR, ARR focuses on accounting profits rather than cash flows.
Key Features of ARR
Focus on Accounting Profits: Relies on net income or accounting profits reported in financial statements.
Percentage Return: Expresses profitability as a percentage, making it easy to interpret.
Simplicity: Does not require complex calculations or advanced financial knowledge.
Advantages of ARR
Ease of Use: ARR is simple to calculate and understand, making it accessible for quick evaluations.
Accounting-Based: Relies on data from financial reports, ensuring consistency with other accounting metrics.
Comparable: Useful for comparing the profitability of multiple projects or investments.
Limitations of ARR
Ignores Time Value of Money: ARR does not account for the declining value of money over time, unlike discounted cash flow methods.
Based on Accounting Profits: Focuses on net income rather than cash flows, which may not accurately reflect a project's true profitability.
No Cash Flow Analysis: Can overlook liquidity issues or variations in cash inflows and outflows.
Subject to Accounting Policies: Results can vary based on how depreciation and other accounting policies are applied.
Decision Rule for ARR
A project is considered acceptable if its ARR exceeds the required or target rate of return set by the organization.
Projects with higher ARR values are prioritized when comparing multiple investment opportunities.
Applications of ARR
Preliminary Screening: Often used for an initial assessment of investment opportunities.
Performance Evaluation: Provides a basic measure of how effectively an investment generates accounting profits.
Capital Budgeting: Serves as one of several tools to analyze potential projects.
Conclusion
The Accounting Rate of Return is a simple and intuitive measure of profitability that emphasizes accounting-based results. While it lacks the sophistication of methods like NPV or IRR, it remains useful for quick comparisons and preliminary decision-making. However, its limitations, especially the omission of the time value of money, should be considered when relying on ARR for investment evaluations.
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