Accounting Rate Of Return
The accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment or asset, compared to the initial investment's cost. The ARR formula divides an asset's average revenue by the company's initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.
Accounting Rate of Return (ARR)
Definition
The Accounting Rate of Return (ARR) is a percentage formula used to evaluate the expected return on an investment or asset compared to the initial investment cost. It is calculated by dividing the average income from the asset by the initial investment, providing an expected return rate over the asset or project's entire lifecycle. It is important to note that ARR does not consider the time value of money or cash flows.
Origin
The concept of ARR originated from traditional accounting and financial analysis methods. As early as the early 20th century, businesses began using this simple ratio to evaluate the potential returns of investment projects. Over time, ARR has become a commonly used tool in capital budgeting decisions.
Categories and Characteristics
ARR has the following key characteristics:
- Simple and Easy to Understand: The calculation method of ARR is relatively simple and does not require complex mathematical operations.
- Does Not Consider Time Value: ARR does not take into account the time value of money, meaning it cannot reflect the value changes of funds at different points in time.
- Based on Accounting Data: ARR relies on data from financial statements, which can be influenced by accounting policies and estimates.
Specific Cases
Case 1: Suppose a company invests $1 million to purchase a machine, which is expected to generate $200,000 in net income annually, with a lifespan of 5 years. The ARR calculation is as follows:
ARR = ($200,000 * 5 years) / $1 million = 1 or 100%
Case 2: A company invests $500,000 to develop new software, which is expected to generate $100,000 in net income annually, with a lifespan of 10 years. The ARR calculation is as follows:
ARR = ($100,000 * 10 years) / $500,000 = 2 or 200%
Common Questions
1. Why does ARR not consider the time value of money?
ARR is a simple evaluation method mainly used for quick estimation of investment returns. It does not consider the time value of money because its calculation method is straightforward, suitable for preliminary project screening.
2. What are the main drawbacks of ARR?
The main drawback of ARR is that it does not consider the time value of money and cash flows, which may lead to overestimation or underestimation of project returns.
