Accounting Rate of Return Method – Calculation

Unlike NPV or Payback which look at Cash, ARR looks at Profit (after Depreciation and Tax).

1. Formula

ARR = (Average Annual Net Profit / Average Investment) * 100

• Average Profit: Sum of PAT for all years / Number of years.
• Average Investment: (Initial Cost + Scrap Value) / 2.

2. Example

• Investment: ₹ 1,00,000. scrap is 0.
• Net Profit After Tax:
  • Year 1: 10,000
  • Year 2: 15,000
  • Year 3: 20,000
• Average Profit: (10+15+20)/3 = ₹ 15,000.
• Average Investment: 1,00,000 / 2 = ₹ 50,000.
• ARR: (15,000 / 50,000) * 100 = 30%.

3. Comparison with other methods

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4. Exam Notes: Writing the Answer

Question: "Define ARR. Why is it different from other methods?" (5 Marks)

Answering Strategy:

1. Unique Feature: "Only method based on Accounting Profit".
2. Formula: Write Average Profit / Average Investment.
3. Criticism: Explain that ₹1 received today is valued same as ₹1 received after 10 years (No TVM), which is a flaw.

Summary

• Usage: Used mainly for performance evaluation (since Managers are judged on Profit), not for investment decision making.

Quiz Time! 🎯

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