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Accounting Rate of Return / Average Rate of Return
While learning about capital budgeting methods like net present value method, internal rate of return method and payback period method, we can observe that all these concepts focus on cash flows only. But accounting rate of return (ARR) method concentrates on expected net operating income to be generated by the investment proposal rather than focusing on cash flows to evaluate an investment proposal.
“The amount of return that any one who is thinking about to start a project or investment proposals , can expect based on an investment made.” Accounting rate of return divides the average annual profit of an entity by the initial investment in order to arrive at the ratio that can be expected ,from the project proposed.This rate will help to decide whether to proceed the project or not.
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ARR = Average annual accounting profit / Initial investment.
1.The greatest advantage is that ARR focuses on accounting net operating income , which is used by various stakeholders like investors ,creditors to evaluate the performance of management.
2.No complexity is there in computing the ARR because it’s very straightforward from the view of computation.
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1.A considerable drawback of ARR is that this method does not take into account the time value of money while computing. And as per time value of money rupee in future is less than rupee in hand now.
2.As it ignores time value of money there arises a wrong conclusion that a project which has higher annual income in the latter years of its useful life may be ranked higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher.
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3. Accounting rate of return method focus on accounting net operating income rather than cash flow. But there are some non cash expenditures and non cash incomes which are considered in computing the accounting profit.
4.The accounting rate of return does not remain constant over the useful life for project. A project may, therefore, look viable in one period but not in another period. Thus it is lacking consistency in decision making