## Accounting Rate of Return (ARR)

ARR measures project profitability using accounting net income rather than cash flows.

> Common Formula:

> ARR = Average Annual Net Income ÷ Average Investment × 100

(Average Investment = (Initial Investment + Salvage Value) ÷ 2)

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### Advantages

#	Advantage	Detail
1	Uses readily available data	Relies on accounting records; no special cash flow estimation needed
2	Consistency in evaluation and performance	The same accounting data used for decision-making is used later to evaluate managerial performance
3	Considers all incomes over entire project life	Unlike Payback, it doesn't ignore post-recovery profits; measures total profitability

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### Disadvantages

#	Disadvantage	Detail
1	Ignores Time Value of Money	Profits earned in Year 1 and Year 10 are weighted equally
2	Dependent on accounting procedures	Different depreciation methods (SLM vs. WDV) produce different ARR for the same project
3	Ignores cash flows	Profit ≠ Cash Flow; a profitable project can still face cash shortfalls
4	Uses only book value of investment	Ignores additional working capital requirements and other non-book outlays

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> Key distinction vs. Payback: Payback ignores post-recovery flows; ARR ignores timing of flows. Both ignore TVM.

Worked example

### Example 1

A project costs ₹10,00,000 (no salvage). Annual net profits: Year 1: ₹1,20,000; Year 2: ₹1,40,000; Year 3: ₹1,60,000; Year 4: ₹1,80,000; Year 5: ₹2,00,000. Average profit = (1,20,000+1,40,000+1,60,000+1,80,000+2,00,000)/5 = ₹1,60,000. Average investment = 10,00,000/2 = ₹5,00,000. ARR = 1,60,000/5,00,000 × 100 = 32%.

### Example 2

Company X uses SLM depreciation and calculates ARR = 25% for a machine. Company Y uses WDV for an identical machine and arrives at ARR = 19%. This illustrates the disadvantage: ARR is not comparable across firms using different accounting methods.

⚠️ Common exam mistakes

Using original investment instead of average investment in the denominator—both formulations exist, but you must be consistent and match the formula given in the question.
Confusing net income with cash flow—ARR uses accounting profit (after depreciation), not operating cash inflow.
Concluding ARR is always better than Payback because it considers the full life—ARR still ignores TVM, so it doesn't correct for the biggest flaw.
Ignoring that ARR thresholds are arbitrary—there's no theoretically grounded cutoff rate the way WACC provides a benchmark for NPV/IRR.

Reference:

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Accounting Rate of Return (ARR) — Merits and Demerits

Worked example

⚠️ Common exam mistakes