Accounting Rate of Return
Accounting Rate of Return (ARR) is a financial metric used to evaluate the profitability of an investment. It is calculated by dividing the average annual accounting profit by the initial investment cost. ARR provides a simple way to assess the potential return on an investment and is often used in conjunction with other financial metrics to make investment decisions.
6 Key excerpts on "Accounting Rate of Return"
- Richard P. Brief, Richard P. Brief(Authors)
- 2013(Publication Date)
- Routledge(Publisher)
...On the Use of the Accounting Rate of Return in Empirical Research Geoffrey Whittington * Introduction Accountants are acutely aware that, despite the proliferation of Accounting Standards, published financial statements contain a good deal of subjective judgment and variety of practice, which make them not strictly comparable between the same company for different years (time series analysis) or between different companies for the same year (cross-sectional analysis). Furthermore, the recent debate on accounting in a period of rapid inflation has served to emphasise that accounting measures of value and income are very different from those of the economist, and a series of academic papers, Harcourt [1965] and Solomon [1966] being seminal works, has demonstrated that there can be important divergences between the Accounting Rate of Return (ARR) 1 and the Internal Rate of Return (IRR) on investment, the latter being the more relevant return for the appraisal of economic performance. In these circumstances, it is not surprising that many accountants are sceptical of the value of using the ARR, calculated from published accounts, in empirical research, particularly in economics, 2 but also in the area of accounting and finance. In this paper, we shall be concerned with the measurement of economic performance ex post i.e. with the comparison of the observed ARR for a year, or the average for a number of years, with the IRR. The latter is defined as that rate of discount which will give a zero initial Net Present Value of the lifetime cash flows of a project or (in the case of the whole firm) a group of projects. The calculation of an ex post IRR for comparison with an ARR calculated from financial reports has a serious practical drawback in the case of a continuing firm: IRR requires estimates of all future cash flows, which will be extremely subjective in a world of uncertainty...
eBook - ePub- Chris Guilding, Kate Mingjie Ji(Authors)
- 2022(Publication Date)
- Routledge(Publisher)
...Try thinking of it as ‘The average amount of money invested in the asset during its life’. At the beginning of 20X0, it is evident that $8,000 is invested in the asset (i.e., the initial investment). At the end of the life of the asset, it is evident that $2,000 is effectively invested, as this is the amount that could be liquidated if the asset is sold. As the asset is worth $8,000 at the beginning of its life and $2,000 at the end of its life, its average value over the duration of its life is $5,000. This is the midpoint between $8,000 and $2,000 and can be computed as follows: ([$8,000 + $2,000] ÷ 2). As the average annual profit is $2,000 and the average investment in the asset is $5,000, the ARR can be computed as follows: ARR = $ 2, 000 $ 5, 000 × 100 = 40 % At first glance, the ARR might appear conceptually appealing. It has major shortcomings, however. These shortcomings include: 1 The ARR fails to consider the period of the investment. Suppose a hotel is deciding whether to take the 40% ARR investment option with a 3-year life described in Box 14.1 or a second $8,000 investment option that has a 10-year life and an ARR of 38%. Both returns appear very high. Consequently, we are left to question: Would you like to make an investment that provides a very high return for 3 years or an investment that provides a very high return for 10 years? Let’s assume that the hotel in question generally makes an average return of 12% on its assets. By investing in the 10-year asset that provides a 38% ARR, it will be able to increase its average return on assets for 7 years longer than if it invests in the 3-year asset that provides a 40% ARR. In this case, it appears that the 10-year 38% ARR investment option is preferable to the 3-year 40% ARR option. 2 The ARR is based on accounting profits. These figures involve some apportioning of cash flows to different accounting periods (e.g., depreciation). As a result, profits are not ‘real’ in a tangible sense...
eBook - ePub- Clive Marsh(Author)
- 2012(Publication Date)
- Kogan Page(Publisher)
...Income is €15,000 per year for Years 1 to 4 and €10,000 per year for Years 5 to 10. ROCE can be calculated using several definitions for profits or investments, and may use different combinations of these. For example the calculation can use average profits, total profits, average investments or initial investments. Therefore, when comparing the ROCE of different companies make sure you are comparing a like-with-like method. ROCE is often used when comparing the return on mutually exclusive projects. A major drawback of the ROCE method is that it does not take account of the timing of cash flows. However, it is a simple and easily understood method that can be used in conjunction with other methods as long as its limitations are understood by users. Accounting Rate of Return (ARR) The ARR method compares profits after depreciation with the original investment or average net book values. It is expressed as a percentage. There are several different ways of calculating the ARR and it is important to know how it has been calculated before using the information for comparative purposes. An example of the formulae is: A weakness of the ARR is that it does not take into account the timing of cash flows, unlike the discounted-cash-flow method, which is explained below. Discounted-cash-flow and net present value These are the principal and most widely used methods of investment appraisal because they take into account the timing of cash flows. Money changes value over time and the discounted-cash-flow technique takes account of this. Two methods that use discounted-cash-flow are the net present value and the internal rate of return...
eBook - ePub- R.A. Rayman(Author)
- 2013(Publication Date)
- Routledge(Publisher)
...Appendix B The ‘accountant's rate of profit' (ARP) and the ‘internal rate of return’ (IRR) The Internal Rate of Return (IRR) The ‘internal rate of return’ is ‘an accurate description of the average rate of return per period over the life of the investment’ (Chapter 7 : 71). Nevertheless, the IRR is not a magnitude which a rational investor should seek to maximize: bigger is not necessarily better. The apparent paradox is easily resolved. The internal rate return of the investment is the rate at which the net present value of the investment is exactly equal to zero. It is equal to r in the equation: ∑ t = 0 n x t (1 + r) t = 0 where x 0, 1, 2, 3, …, n, is the net revenue series or equity cash flow. The possibility of multiple solutions does not exist in the case of financial investments where contributions from investors are followed by distributions to investors. Three investments of this type are described in Table B.1. Table B.1 The equity cash flow from three alternative investments Beginning of Year 1 End of Year 1 End of Year 2 Internal rate of return Investment A [ Contributions − Distributions + ] − £1,000 + £1,240 24% p.a. Investment B [ Contributions − Distributions + ] − £1,000 + £600 + £720 20% p.a. Investment C [ Contributions − Distributions + ] − £1,000 + £0 + £1,369 17% p.a. If the contributions and distributions are paid and received at the stated dates, the internal rate of return is an accurate description of the average annual return over the life of the investment. The IRR represents the rate of interest that the contribution would have to earn in a bank account in order to produce the same distributions at the same dates. Although the IRR is an accurate description of the average annual rate of return earned by the three investments, it is not possible to make a rational choice between the investments on the basis of the size of the IRR alone. Suppose the investor does not intend to spend the proceeds of any investment until the end of Year 2...
eBook - ePubBusiness
The Ultimate Resource
- Bloomsbury Publishing(Author)
- 2011(Publication Date)
...Calculating Rate of Return WHAT IT MEASURES The annual return on an investment, expressed as a percentage of the total amount invested. It also measures the yield of a fixed-income security. WHY IT IS IMPORTANT Rate of return is a simple and straightforward way to determine how much investors are being paid for the use of their money, so that they can then compare various investments and select the best—based, of course, on individual goals and acceptable levels of risk. Rate of return has a second and equally vital purpose: as a common denominator that measures a company’s financial performance, for example in terms of rate of return on assets, equity, or sales. HOW IT WORKS IN PRACTICE There is a basic formula that will serve most needs, at least initially: [(current value of amount invested – original value of amount invested) / original value of amount invested] × 100 percent = rate of return If $1,000 in capital is invested in stock, and one year later the investment yields $1,100, the rate of return of the investment is calculated like this: [(1100 – 1000) / 1000)] × 100 percent = 100 / 1000 × 100 percent = 10 percent rate of return Now, assume $1,000 is invested again. One year later, the investment grows to $2,000 in value, but after another year the value of the investment falls to $1,200...
eBook - ePub- Bijan Vasigh, Javad Gorjidooz(Authors)
- 2016(Publication Date)
- Routledge(Publisher)
...In addition, the chapter presents the possibility of multiple rates of return existing and describes the use of modified rate of return analysis. ◆ Rate of Return Calculation ○ Interpretation of Rate of Return Values ○ Trial and Error Method ◆ Rate of Return of Bonds ◆ Evaluating Mutually Exclusive Projects ○ Incremental Cash Flows ○ Cost-based Alternatives ○ Revenue-based Alternatives ○ Equal-life Service Requirement ◆ Evaluating Independent Projects ◆ Complications with Rate of Return ○ Multiple Rates of Return Scenario ○ ROR Reinvestment Rate Assumption ○ Modified Rate of Return Analysis ◆ Using Spreadsheets for Rate of Return Computation ◆ Summary ◆ Discussion Questions and Problems Rate of Return Calculation Rate of return (ROR) analysis is used often by professional engineers and investors to evaluate the rate of return of their investments in a single asset or security, a portfolio of assets or securities, or mutual funds. Newnan (Newnan et al. 2012) defines rate of return as the interest rate at which the present worth and the annual worth are equal to zero. But Blank (Blank and Tarquin 2014) defines rate of return as “the rate paid on the unpaid balance of borrowed money, or the rate earned on the uncovered balance of an investment, so that the final payment or receipt brings the balance to exactly zero with interest considered.” Aviation Snippet Airlines have been a serial killer of capital. We have done a good job for consumers of selling our product at less than cost. In our view the industry is a giant charity. John Owen, JetBlue In this book, the ROR, which is also called internal rate of return (IRR), is defined as the interest rate (i *) that sets present worth of all cash flows, both inflows and outflows, to zero...
