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What is accounting rate of return (ARR)?

The Accounting Rate of Return (ARR), also known as the Average Accounting Return (AAR), is a financial metric used to evaluate the profitability of an investment or project. It measures the average annual accounting profit generated by the investment as a percentage of the initial investment cost.

Here’s how the Accounting Rate of Return is calculated:

1. Determine the average annual accounting profit: Calculate the average annual accounting profit generated by the investment. This is typically calculated by dividing the total accounting profit over the investment’s useful life by the number of years.

2. Calculate the initial investment cost: Determine the initial cost or investment outlay required for the project. This includes any capital expenditures, equipment purchases, or other costs associated with the investment.

3. Calculate the Accounting Rate of Return: Divide the average annual accounting profit by the initial investment cost and multiply by 100 to express it as a percentage.

Accounting Rate of Return = (Average Annual Accounting Profit / Initial Investment Cost) * 100

The resulting percentage represents the accounting rate of return. It indicates the average annual profitability of the investment as a percentage of the initial investment cost.

The Accounting Rate of Return is often used as a simplified measure to assess the financial viability of an investment or project. However, it has some limitations. For instance, it focuses solely on accounting profits and does not consider the time value of money or the cash flows generated by the investment. It also does not account for the project’s risk or the timing of cash flows. Therefore, it is advisable to consider other financial metrics and conduct a comprehensive analysis when evaluating investment opportunities.