what is the accounting rate of return for proposal x? course hero

What Are the Decision Rules for Accounting Rate of Return?

When a company is presented with the option of multiple projects to invest in, the decision rule states that a company should accept the project with the highest accounting rate of return as long as the return is at least equal to the cost of capital.

What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment or asset, compared to the initial investment's cost. The ARR formula divides an asset's average revenue by the company's initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

What Is the Difference Between ARR and IRR?

The main difference between ARR and IRR is that IRR is a discounted cash flow formula while ARR is a non-discounted cash flow formula. A non-discounted cash flow formula does not take into consideration the present value of future cash flows that will be generated by an asset or project. In this regard, ARR does not include the time value of money whereby the value of a dollar is worth more today than tomorrow because it can be invested.

What is ARR in accounting?

ARR factors in any possible annual expenses, including depreciation, associated with the project. Depreciation is a helpful accounting convention whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset.

How does depreciation affect the return on investment?

Depreciation will reduce the accounting rate of return. Depreciation is a direct cost and reduces the value of an asset or profit of a company. As such, it will reduce the return of an investment or project like any other cost.

How to calculate annual net profit?

If the investment is a fixed asset such as property, plant, and equipment (PP&E), subtract any depreciation expense from the annual revenue to achieve the annual net profit.

Why is rate of return important?

The accounting rate of return is a capital budgeting metric that's useful if you want to calculate an investment's profitability quickly. Businesses use ARR primarily to compare multiple projects to determine the expected rate of return of each project, or to help decide on an investment or an acquisition .

What happens if the ARR is less than the required rate of return?

If the ARR is less than the required rate of return, the project should be rejected. Therefore, the higher the ARR, the more profitable the company will become. Read more about hurdle rates.

What is ARR in accounting?

an asset is expected to generate divided by its average capital cost, expressed as an annual percentage. The ARR is a formula used to make capital budgeting decisions. It is used in situations where companies are deciding on whether or not to invest in an asset (a project, an acquisition, etc.) based on the future net earnings expected compared ...

What does 5% ARR mean?

If the ARR is equal to 5%, this means that the project is expected to earn five cents for every dollar invested per year. In terms of decision making, if the ARR is equal to or greater than a company’s required rate of return.

What is the IRR?

Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.

Why is comparative metric not an ideal comparative metric between projects?

It is not an ideal comparative metric between projects because different projects have different variables such as time and other non-financial factors to consider.

Is ARR a good tool?

Although ARR is an effective tool to grasp a general idea of whether to proceed with a project in terms of its profitability, there are several limitations to this approach:

How to calculate expected accounting rate of return?

Under this method, the asset’s expected accounting rate of return (ARR) is computed by dividing the expected incremental net operating income by the initial investment and then compared to the management’s desired rate of return to accept or reject a proposal. If the asset’s expected accounting rate of return is greater than or equal to the management’s desired rate of return, the proposal is accepted. Otherwise, it is rejected. The accounting rate of return is computed using the following formula:

Why is the accounting rate of return method important?

The accounting rate of return method is equally beneficial to evaluate cost reduction projects. The accounting rate of return of the assets that are purchased with a view to reduce business costs is computed using the following formula:

What is the ARR method?

But accounting rate of return (ARR) method uses expected net operating income to be generated by the investment proposal rather than focusing on cash flows to evaluate an investment proposal.

Which proposal is the best for a good year manufacturing company?

If only accounting rate of return is considered, the proposal B is the best proposal for Good Year manufacturing company because its expected accounting rate of return is the highest among three proposals.

Is rate of return simple to calculate?

Accounting rate of return is simple and straightforward to comp ute.

Does the rate of return take into account the time value of money?

Accounting rate of return method does not take into account the time value of money. Under this method a dollar in hand and a dollar to be received in future are considered of equal value.

Does the accounting rate of return remain constant?

The accounting rate of return does not remain constant over useful life for many projects. A project may, therefore, look desirable in one period but undesirable in another period.

Why is it important to understand the concept of accounting rate of return?

It is important to understand the concept of accounting rate of return because it is used by businesses to decide whether or not to go ahead with an investment based on the likely return expected from it.

What is accounting rate of return?

The term “accounting rate of return” refers to the percentage rate of return that is expected on an investment or an asset as against the initial investment that helps in management decision making. In other words, it helps in deciding whether or not to go ahead with a new investment based on its expected profitability.

What Does Accounting Rate of Return Mean?

What is the definition of accounting rate of return? ARR is an important calculation because it helps investors analyze the risk involved in making an investment and decided whether the earnings are high enough to accept the risk level.

How to calculate rate of return?

The accounting rate of return formula is calculated by dividing the income from your investment by the cost of the investment. Usually both of these numbers are either annual numbers or an average of annual numbers. You can also use monthly or even weekly numbers. The time length doesn’t matter.

What is the ARR in accounting?

Definition: The accounting rate of return (ARR), also called the simple or average rate of return, is an investment formula used to measure the annual earnings or profit an investment is expected to make. In other words, it calculates how much money or return you as an investor will make on your investment.

How to tell if an investment is worthwhile?

The only way to tell whether an investment is worthwhile or not is to measure the return or amount of money the investment has made and is expected to make in the future. To do this we must know how to calculate the accounting rate of return.

Is a racecar a good investment?

Obviously, this is a huge return and a racecar isn’t your typical investment. This great return might have had more to do with your driving abilities than the actual investment, but the principle is the same. I would still tell you to keep putting money into your racecar with returns like this.

Arr Formula

Components of Arr

• If the ARR is equal to 5%, this means that the project is expected to earn five cents for every dollar invested per year. In terms of decision making, if the ARR is equal to or greater than a company’s required rate of return, the project is acceptable because the company will earn at least the required rate of return. If the ARR is less than the r...

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Arr – Example 1

Arr – Example 2

Limitations to Accounting Rate of Return

Additional Resources