The Accounting Rate of Return (ARR) is a financial metric used in capital budgeting to assess the profitability of investments. It calculates the average annual profit divided by the initial investment cost, providing a percentage that indicates the expected annual return. While ARR offers a straightforward profitability indicator, it does not account for the time value of money, making it essential to use alongside other financial analysis tools for a complete evaluation.
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ARR is calculated by dividing the average annual profit by the initial investment cost
Determining the average annual profit
The average annual profit is calculated by summing the expected profits for each year and dividing by the number of years
Components of average annual profit
The average annual profit includes operational costs and expenses, providing a realistic view of the investment's profitability
The initial investment is the sum of funds used to start the project
ARR is a significant tool for businesses when evaluating capital investment opportunities
ARR simplifies complex financial projections into a single percentage, making it accessible to decision-makers without a financial background
ARR can be used to compare potential projects with varying costs and profit expectations to determine which is more financially sound
ARR does not consider the time value of money, which can result in an overestimation of the project's financial benefits
ARR should be used in conjunction with other financial analysis tools as it does not account for cash flow timing or the time value of money
A thorough understanding of ARR's limitations is necessary for accurate financial analysis and business decision-making
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Purpose of ARR in Capital Budgeting
ARR assesses expected profitability of investments or projects.
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ARR Calculation: Average Annual Profit
Sum expected profits over investment life, divide by number of years.
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ARR Limitation: Time Value of Money
ARR ignores time value of money, may overestimate financial benefits.
