Financial Management

Accounting Rate of Return: Investment Appraisal Technique

What is an Investment Appraisal Technique?

The investment appraisal approach is a way for appraising financial assets in accordance with their anticipated future cash flows. It is frequently used to determine the value of real estate and securities.

The three kinds of investment evaluation methodologies are discounted cash flow (DCF), comparative sales analysis (CSA), and market approach. Each of these approaches has distinct advantages and disadvantages, but they are all used to determine the property’s fair market value.

What is Accounting Rate of Return?

The accounting rate of return, or ARR, is another method of investment appraisal. The accounting rate of return measures the profit generated compared to the initial investment. 

The accounting rate of return is an important metric in finance. It is used to compare the profitability of different investments. The accounting rate of return can be calculated by dividing the earnings generated on an investment by the amount of money invested.

The accounting rate of return (ARR) computes the return on investment by taking net income fluctuations into account. It indicates how much additional revenue the corporation may anticipate from the planned project. ARR relates income to the initial investment rather than cash flows, unlike the payback technique. This strategy is advantageous because it examines revenues, cost savings, and costs related with the investment and, in certain situations, can offer a more full picture of the impact, as opposed to relying just on cash flows generated.

How to Calculate ARR?

Following is the formula to calculate Accounting rate of return.

Accounting Rate of Return: Investment Appraisal Technique

Incremental revenues show the increase in revenue if the investment is made vs if it is refused. Included in the rise in revenues are any cost savings realised as a result of the project. The change in expenditures if the initiative is accepted as opposed to preserving the status quo is represented by incremental expenses. Depreciation of the purchased asset is included in incremental expenditures. Incremental net income is the difference between incremental revenues and incremental costs. Before calculating ARR, the initial investment must be deducted by the capital asset’s salvage (residual) value.

Advantages of Accounting Rate of Return Method

There are two main advantages of using this method of investment appraisal. The first is that it is relatively easy to calculate (at least, compared to other methods such as internal rate of return).

It also allows you to easily compare the business’s profitability at present as both figures would be expressed in the form of a percentage.

Moreover, the formula considers the earnings across the project’s entire lifetime, rather than only considering the net inflows only before the investment cost is recovered (like in the payback period).

On the other hand, there are some disadvantages of using this method. First of all, it doesn’t consider the time value of money either, as the payback period.

The time value of money refers to the future value of a particular amount of money. For example, the value of $10 today will fall in the future as a result of inflation. This means that the figures for cash inflows and outflows, and therefore the accounting rate of return, are inaccurate.

Disadvantages of Accounting Rate of Return Method

When compared to other approaches to investment evaluation, the ARR prioritises profits above cash flow as its primary consideration. It is influenced by non-cash, non-objective factors like the rate of depreciation that is used in the calculation of profits, for example. In addition, the ARR does not take into consideration the sequence in which earnings are made.

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