Accounting Rate of Return (ARR)
Prerequisites
Before studying this chapter, make sure you understand:
- Goals - Profit Maximization - ARR is based on Accounting Profit
- Capital Budgeting Decisions - How evaluation leads to selection
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:
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
Merits
- Simplicity: Uses readily available accounting data.
- Total Benefits: Considers profits over the entire life (unlike Payback).
- Profit Focus: Aligns with 'Profit Maximization' goal.
Demerits
- Ignores Time Value: ₹1 profit in Year 5 = ₹1 in Year 1. (Major Flaw)
- Accounting Profit: Ignores cash flows (Profit ± Cash).
- Averaging: Use of averages hides yearly fluctuations.
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.
- Earnings Before Dep & Tax (EBDT)
- Less: Depreciation
- Earnings Before Tax (EBT)
- Less: Tax
- Profit After Tax (PAT) → Use this for ARR
- Add: Depreciation
- Cash Inflow → Use this for Payback/NPV
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:
- Average Profit = ₹80,000 / 4 = ₹20,000.
- Average Investment = ₹2,00,000 / 2 = ₹1,00,000.
- 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! 🎯
Test Your Knowledge
Question 1 of 2
1. ARR formula uses: