Investments Decisions – Accounting Rate of Return (ARR)

Calculating Accounting Rate of Return
ARR= Average Net ProfitAverage Book Value
The accounting rate of return simply involves using accounting numbers, average net profit coming from a company’s income statement and average book value of the investment coming from the company’s balance sheet. These two accounting figures divided together gives as the accounting rate of return.
Management will usually have a predetermined ARR measure. If the calculated ARR is greater than the ARR set by management then the project should accepted. For example if management want an investment to have a ARR of 15% and the calculated ARR is 20% then the projected would be accepted.
Example 1
A company wants to determine by way of ARR if building a construction plant is worthwhile. The initial cost of the plant is $300,000. The plant will be depreciated each year over its useful life of 3 years.
Year 1 Year 2 Year 3
Revenue 200,000 $300,000 $350,000
Expenses $50,000 $60,000 $75,000
Depreciation 100,000 $100,000 $100,000
Earnings before tax $50,000 $140,000 175,000
Taxed (30%) $15,000 $42,000 52,500
Net Profit $35,000 $98,000 122,500
The average net profit is easy to calculate. It is simply adding up the net profit the company is expected to make over the next 3 years and dividing it by 3.

Averge net profit
($35,000 + $98,000 + $122,500)/3
Averge net profit = $85,166.67
The average book value is the simply the average value of the investment over the 3 year period. So in year 0 the plant is worth $300,000, in year 1 the plant is worth $200,000, in year 2 the plant is worth $100,000 and by the end of the 3rd year the plant is worth $0.
Averge book value of investment = ($300,000 + $200,000 +$100,000 + 0)/4
Averge book value of investment = $150,000
ARR =Average Net ProfitAverage Book Value
ARR =$85,166.67$150,000
ARR = 0.5678 or 56.78%