Accounting Rate of Return Method as an Investment Rule. Application and possible Problems

There are various ways of calculating the ARR. Three are shown below:

• Method 1: Average annual accounting profit over the project life/ Average investment in the project,

• Method 2: Average annual accounting profit over the project life/Initial investment in the project

• Method 3: For each year of the project calculate profit as well as the amount of investment (after depreciation) devoted to the project at the beginning of the year. Divide profit by investment for each year separately to obtain annual ARR. Then average the ARR over the years.

Usually ‘profit’ is calculated after deduction of depreciation. Usually required investment in working capital is added to the ‘investment’ figure.

Average – arithmetic mean, profit – EBIT (profit before taxes and interests of a particular project), average investment – book value of assets tied up (in the project). Straight-line method of estimating average returns from an investment, it uses accrual based financial statements instead of compound or discounted cash flows. Ratio that expresses the EBIT as a percentage of the capital employed at the end of accounting period.

Applications: -quick estimate of a project’s worth over accounting period; -easy to calculate; -used for purpose of comparison;

Drawbacks of accounting rate of return: 1) It ignores the time value of money/opportunity cost of capital principle. No allowance is made for the fact that cash received in year 2 is worth more than an identical sum received in year 4. 2) By using accounting profit managers ignore the difference between depreciation and the actual timing of capital expenditure (when cash actually flows out). They also ignore the timing of other cash flows such as working capital changes. ARR also fails to consider many other items placed in the profit statement, which do not represent cash flows. ‘Profit’ is vulnerable to manipulation. 3) In mutually exclusive project situations (accepting one project excludes the possibility of accepting another and a choice has to be made – frequently between two value-enhancing projects) ARR can lead to a project with a high percentage ARR being preferred to a project with a lower ARR but which yields higher shareholder wealth. 4) it is insensitive to the timing of cash flows, - uses profit rather than cash flows, which are more important for investors,- doesn’t adjust the greater risk to longer term forecast.

A method of comparing the average profits you expect to the amount you need to invest.

Straight-line method of estimating average returns from an investment, it uses accrual based financial statements instead of compound or discounted cash flows. Ratio that expresses the EBIT as a percentage of the capital employed at the end of accounting period.

ARR=average profit/average investment, or,

ARR=annual average cash inflow/total cash outflow

Average – arithmetic mean, profit – EBIT (profit before taxes and interests of a particular project), average investment – book value of assets tied up (in the project), or

Problems: - it is insensitive to the timing of cash flows, (a postponement of all cash inflows reduces the value of investment but does not affect the accounting rate of return); - uses profit rather than cash flows, which are more important for investors; -can be affected by non-cash items such as depreciation and bad debts when calculating profits, the change of methods for depreciation can be manipulated and lead to higher profits,- doesn’t adjust the greater risk to longer term forecast, doesn’t take into account the time value of money (renders an artificially high level of return for capital investment over traditional financial investment), can be calculated in different ways and give different results.

Benefits: -quick estimate of a project’s worth over accounting period; -easy to calculate; -used for purpose of comparison; similar to ROI (return on investment or return on capital employed), provides a useful basis for comparison of profitability and risk of various investment options, often used by companies to determine which of several competing projects is likely to offer the highest reward-to-risk ratio; After the purchase has been made, companies can use the ARR method to track the profitability and cost effectiveness of the capital investment.