When a company makes an investment it evaluates the financial feasibility of the investment. This process is called investment appraisal. Investment appraisal is a critical stage of investment because it allows the company to invest funds in the most optimal options.
The investment appraisal approach is a way of appraising financial assets following 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 the 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 considering net income fluctuations. It indicates how much additional revenue the corporation may anticipate from the planned project. Unlike the payback technique, ARR relates income to the initial investment rather than cash flows. This strategy is advantageous because it examines revenues, cost savings, and costs related to the investment. In certain situations, it can offer a more full picture of the impact instead of relying just on cash flows generated.
How to Calculate ARR?
Following is the formula to calculate the Accounting rate of return.
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 from the capital asset’s salvage (residual) value.
Advantages of Accounting Rate of Return Method
There are many advantages to 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).
Another advantage is that the ARR method considers the entire lifespan of the investment. It takes into account the profits generated throughout the investment’s existence, which provides a more comprehensive view of its profitability. This can be particularly helpful if you’re planning for the long term and want to assess the overall return on your investment.
Disadvantages of Accounting Rate of Return Method
On the other hand, there are some disadvantages to 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.
The ARR method presents a limited view of potential investments. It only looks at the accounting data about a project’s expected returns. It doesn’t take into account any outside factors, like changes in interest rates or market conditions, that could affect the project’s success or failure. This lack of a thorough analysis can cause investors to make wrong assumptions about an investment’s real economic value, which could lead to mistakes that cost them money in the long run.
Second, many critics say that the ARR method doesn’t take time value into account enough when figuring out how profitable an investment is.
In conclusion, the accounting rate of return is a useful tool for evaluating the profitability of an investment. It provides a simple and straightforward measure of the average annual return on an investment based on its initial cost. However, it has limitations and should not be used as the sole criteria for decision-making. Other factors such as risk, time value of money, and cash flows should also be considered. Furthermore, the accounting rate of return does not account for changes in market conditions or inflation. Therefore, it is important to use this metric in conjunction with other financial analysis tools to make sound investment decisions.