A

Seminar on

Accounting Rate Of Return (ARR)

Submitted to
Shivaji University Kolhapur.

By

Name- Mr. Madan Shirkant Hagir

MBA-I (SEM-II)
DIV- (A)
Roll No. 18

Under the guidance of

Mrs. V.B.Shah

Through

Rayat Shikshan Sanstha’s

“Karmaveer Bharuao Patil Institute of Management
Studies & Research, Satara.”

Year
2011-2012

Accounting Rate of Return (ARR)

 Accounting Rate of Return of Average Rate of Return it is the
method of evaluating capital Investment proposals . A number of
appraisal methods may be recommended for evaluating the capital
expenditure proposals.

The ARR is based on the accounting concept of Return on

investment or Rate of Return. The ARR may be defined as the annualized
net income earned on the average funds invested in a project. In other
words the annual returns of a project are expressed as percentage of the
net investment in the project.

Computation of ARR : Symbolically

Average Annual Profit (after Tax)
ARR = x 100
Average investment in the project

This clearly shows that the ARR is measure based on the accounting
profit rather than the cash flows and is very similar to the measure of
rate of return on capital employed, which is generally used to measure
the overall profitability of the firm. The calculation of ARR may be further
discussed with reference to equal annual profits and unequal annual
profits as follows:-

• Equal Profits:
In case the expected profits(after Tax) generated by a project are
equal for all the years than the annual profit itself is the average profits.
So, this annual profit will be compared with the average investment to
find out the ARR as follows.

Annual Profit (after Tax)

ARR = x 100
Average investment in the project

• Unequal Profits:
If the project is expected to generate unequal profits on uneven
stream of profit over different year, then the ARR may be calculated by
finding out the average annual profits and then comparing it with the
average investment of the project as follows:

Average Annual Profit (after Tax)

ARR = x 100
Average investment in the project

In other the cases, the average investment of the project, which is

used as the denominator of the ARR formula, is to be calculated.

Average Investment:-
The average investment refers to the average quantum of funds
that remains invested of blocked in the proposal over its economic life.
The average investment of a proposal is affected by the method of
depreciation, salvage value and the additional working capital required
by the proposal. The following two approaches are available to calculate
the average investment.

1.Initial cash outlay as average investment:-

In this case, the original cost of investment & the installation exp if
any, is taken as the amount invested in the project for e.g. a project of
Rs. 1.50.000/- every year. The ARR for the proposal would b 15% (i.e. Rs.
1.50.000/10.00.000x100) Theoretically, this approach of average
investment seems to be good out taking the initial cost as the average
investment is definitely not current on logical & technical grounds.
2.Average annual book value after depr. As average
investment:-
In this case, the average annual book value (after depr.) of the
proposal is taken as the average investment of the proposal First, find
out the opening book values & the closing book values of the opening &
closing values for a particular year will depend upon the amount of depr.
For the year. Second find out the average book values for all the years
by taking the simple arithmetic mean of the opening & closing book
values. Third, find out the average of all the yearly averages. This
average will be the average investment of the proposal however; the
following points regarding depreciation are worth nothing.
In case the firm has adopted a method of depreciation other than
the straight line method, then the above procedure of finding out the
average investment may be adopted. However if the firm has adopted
the straight line method of depreciation to write off the project over its
useful economic life, then a shortcut method is also available as follows.
Short – cut method to find out the average investment:-
If the firm provides depreciation as per straight line method then
the amount of depreciation for all the year would be same & is equal to
(initial cost + installation expenses - salvage value)/ number of years.
This amount of depreciation will be calculated from the opening book
values to find out the closing book values for different years. The
average of these opening & closing book values will also decrease
gradually every year by the amount of annual depr. In such a case, the
average investment of the proposal over its economic life can now be
calculated as :

Average investment = ½ (Initial cost+ Installation Expenses-

Salvage value) +
salvage value

It may be noted that in the above equation the amount of salvage

value has been first deducted & later added back. The salves value has
been deducted to find out the annual amount of depreciation. However,
this amount of salvage value remains blocked in the proposal & its
realized only at the end of the economic life proposal. Therefore, the
amount of salvage value has been added back to find out the average
investment.
For example, ABC ltd. Takes a project costing Rs. 120.000 with
expected life of 5 yrs. & the salvage value of Rs. 20.000 The average
investment of proposal is :
Average Investment = ½ (12.000-20.0000)+20000
= 100.000/2 + 20.000
= Rs. 70.000

The average investment can also be calculated as follows :

Year Opening BV Closing BV Average BV (Book Value)

1 Rs 120.000 Rs 100.000 110.000
2 100.000 80.000 90.000
3 80.000 60.000 70.000
4 60.000 40.000 50.000
5 40.000 20.000 30.000
Total 350.000
Average investment = Rs 350.000/5
= Rs. 70000

• The additional working capital :-

Some times, the project may also require additional working capital
for its smooth operations. Though this additional working capital will be
released back, when the proposed will be scrapped & terminated, yet
this amount of additional working capital is blocked throughout the life of
the project. So, this additional working capital entails the investment of
founds of the firm & should also be added to the average investment
calculated as above. The average investment in any proposal (required
to find out the ARR) may there fore,be calculated as follows.

Average Investment = ½ (Initial cost +Installation exp-Salvage value)

+ Salvage value + Additional working capital

To continue with the above example, the project requires an

additional working capital of Rs. 20.000 & is expected to generate annual
average profit (after Tax) of Rs. 18.000 then the average investment &
the ARR can be calculated as follows :

Average Investment = 1/2 (120.000 – 20.000)+20000+20.000

= 90.000

Average Annual Profit (after Tax)

ARR = x 100
Average investment in the project

18.000
ARR = x 100
90.000

ARR = 20 %

The Decision Rule :

The ARR calculated as above is compared with the prespecified rate

of return. Obviously if the ARR is more than the pre-specified rate of
return, then the project is likely to be accepted, otherwise not for
example, in the above case the ARR of the ARR of the proposal has been
found to be 20%. In case, The firm requires a rate of return of at least
18% then this proposal is acceptable. However, if the minimum rate of
return of the firm is 22% then this proposal is likely to be rejected. The
ARR can also be used to rank various mutually exclusive proposals. The
project with the highest ARR will have the top priority while the project
with the lowest ARR will be assigned lowest priority.

The critical Evaluation:-

The ARR is relatively simple to calculate & easy to apply. The
relevant data & information required for its calculation is readily
available in the accounting records.
ARR has certain limitations and drawbacks when used as a
technique of project evaluation as follows:-
1. It ignores the time value of money and consider the profit earned in
the 1st year as equal to the profits earned in later years.
2. The ARR is based on the accounting profit rather than the cash
flows.
3. The ARR techniques also ignores the salvage value of the proposal.
In real sense, the salvage value is also a return from the proposal
and should be considered.
4. The ARR also fails to recognize the size of the investment required
for the project. Particularly, in case of mutually exclusive proposals,
the two projects having significantly different initial costs, may have
same ARR.

ARR is simple but crude method of evaluation of capital budgeting

proposal. As it is based on the accounting profits (and not on the cash
flows) it does not help in understanding the contribution of the proposals
towards maximizations of the wealth of the shareholders. In fact, the
ARR lacks much to be a sound technique for evaluation of capital
budgeting proposals. The method shares all of the shortcomings of the
payback period method as the ARR also relates only two of the three
critical aspects of any projects.