Home > Topics > Fundamentals of Financial Management > Accounting Rate of Return (ARR)
← PreviousNext →

Accounting Rate of Return (ARR)

Prerequisites

Before studying this chapter, make sure you understand:

1. Definition

Accounting Rate of Return (ARR), also known as Average Rate of Return, measures the profitability of an investment based on the accounting information (Net Profit After Tax) rather than cash flows.

Distinction: It is the ONLY capital budgeting method that uses Accounting Profits (Profit After Tax) instead of Cash Flows.

Decision Rule:

  • Accept: If ARR > Target Rate (Minimum Required Rate)
  • Reject: If ARR < Target Rate
  • Ranking: Project with higher ARR is preferred.

2. Formula

There are multiple variations, but the most common one is:

Formula

ARR = (Average Annual Profit After Tax / Average Investment) × 100

Where:

  • Average Profit = Total Profits / Number of Years
  • Average Investment = (Initial Investment + Scrap Value) / 2

(Note: Sometimes examiners ask to use Initial Investment instead of Average Investment. Read the question carefully. Standard academic practice prefers Average Investment.)

3. Numerical Problem

Problem: A project requires an investment of ₹5,00,000. It has a life of 5 years and scrap value of ₹20,000. The Profits After Tax (PAT) are:

  • Year 1: ₹40,000
  • Year 2: ₹60,000
  • Year 3: ₹70,000
  • Year 4: ₹50,000
  • Year 5: ₹30,000

Calculate ARR.

Solution:

Step 1: Calculate Average Profit Total Profit = 40k + 60k + 70k + 50k + 30k = ₹2,50,000 Average Profit = Total Profit / 5 = ₹2,50,000 / 5 = ₹50,000

Step 2: Calculate Average Investment Formula: (Initial Invest + Scrap) / 2 = (5,00,000 + 20,000) / 2 = 5,20,000 / 2 = ₹2,60,000

Step 3: Calculate ARR ARR = (Av. Profit / Av. Invest) × 100 = (50,000 / 2,60,000) × 100 = 0.1923 × 100

Answer: ARR is 19.23%.

4. Merits and Demerits

Loading comparison…

5. Profit vs Cash Flow Conversion

Often exam questions give "Cash Flow Before Depreciation and Tax". You must convert it to "Profit After Tax" for ARR calculation.

Loading note…

Exam Pattern Questions and Answers

Question 1: "Calculate Average Rate of Return." (4 Marks) Given:

  • Investment: ₹2,00,000 (No scrap)
  • Total Profit After Tax for 4 years: ₹80,000.

Solution:

  1. Average Profit = ₹80,000 / 4 = ₹20,000.
  2. Average Investment = ₹2,00,000 / 2 = ₹1,00,000.
  3. ARR = (20,000 / 1,00,000) × 100 = 20%.

Question 2: "Why is ARR unique among capital budgeting techniques?" (2 Marks)

Answer: ARR is unique because it is the only method that uses Accounting Profit concepts (like Net Income) for evaluation, whereas all other major methods (Payback, NPV, IRR, PI) are based on Cash Flows.

Quiz Time! 🎯

Loading quiz…

← PreviousNext →