It is one of the methods of evaluating projects. In simple words, we can define ARR as return on capital employed (ROCE). It is input output ratio of the project under consideration. That is; how much money is invested and how much money in return the company gets. The business accepts the projects if the ARR exceeds the target rate or cut-off rate.
Formula
ARR = Profit before interest & tax / capital employed
Or
ARR = Average profit / Average investment
Benefits
- It is easier to calculate
- It takes into account ratio of input and output.
Disadvantages
- It ignores the time value of money.
- It ignores the risk associated with the long term project. Because, it is not an easy task to predict future cash flows and ARR does not take into account this factor.
- It completely ignores the non-financial performance indicators.
- It can be easily manipulated by doing changes in the figures involved such as by changing depreciation method. The profit can be increased to calculate desired ARR.
- You cannot compare investment of different sizes using this method.
Example
CBM is considering investing in new machinery due to the reduced level of performance of the old one. The new machine will cost $ 400,000. The estimated useful life of the machinery is 10 years. The introduction of this machine into the production will increase profits by $ 140,000.
Required
Calculate Accounting rate of return for the above capital project.
Solution
Depreciation expense = cost – scrap value / useful life = 400,000 – 0 / 10 = $ 40,000
Net profit = 140,000 – 40,000 = $ 100,000
ARR = Average profit / Average investment = 100,000 / 400,000 = 25 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}