The accounting rate of return also known as the return an investment (ROI) uses accounting information as revealed by analytical, statement to measure the profitability of an investment.
The accounting rate of an return is the ratio of the average after tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciation constantly.
Alternatively l, it can be found out by dividing the total of the investment LS book values after depreciation by the life of the project.
It is important to note that accounting rate of return is calculated using accounting profits which are operating cash flows adjusted to take account of depreciation.Accounting profits, then are not flows, since depreciation is an accounting adjustment which does not correspond to a movement of cash.
The decision rate here would be to accept an investment project if its accounting rate of return was greater than a target or hurdle rate of return. If only one of two investment, the highest accounting rate of return should be accepted.
Calculation of the accounting rate of return
Total cash profit 21000×5 = 1050000
Total depreciation = 570000-70000= 500000
Accounting profit = 5500000
Average accounting profit= 550000/5=110000
Average investment =(570000+70000)/2
Accounting rate of return= 100×(110000)
For machine 2
Total cash profit = 510000×5= 2550000
Total depreciation = 1616000-301000=1315000
Total accounting profit= 1235000
Average accounting profit = 1235000/5=247000 per year
Average investment= 1616000+301000/2= 958500
Accounting rate return= 100×247000
The recommendation is that machine1 should be accepted as it has a higher accounting rate of return.
Advantage of the accounting rate of return method
There are number of reasons for the popularity of the accounting rate of return.Even thought has no theoretical foundation as a method for security optimal investment decision.
For example, it gives a value in percentage terms. A familiar measures of return which can be compared with accounting ratio used by accountants and financial analysts to assets company performance.
It is also a reasonably simple method to apply and can be used to compare mutually exclusive projects. Unlike the payback method , it consider all cash flows using during the life of an investment project and can indicate whether a project is a good one by comparing the ARR of the project with a hurdle rate, for example is current ROCE.
Disadvantage of accounting rate of return
While it can be agreed that the accounting rate od return method provides us with useful information about a project, as a method provides us with useful information about a project, as a method of investment appraisal it has significant drawback.
It is not based on cash, but based on accounting profit which is open to manipulation and is not linked to the fundamental object ignores the timing of cash flow.
Both project have the average investment.
Both project have the same annual accounting profit.
Project A (-250+1000+1000+20750)4=$5625
So this accounting, rates of return are identical too
ARR = (100×5625)/2250= 25%
But project B has a smooth pattern of return whereas project offer little in the first three years and a large return in to final year.
As an accept -or -reject criterion, this method will accept all those projects whose ARR is higher than the minimum rate established by the managment and reject projects which have ARR Less than the minimum rate. This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.
Evaluation of ARR method
The ARR method may claim some merits
1) Simplicity – The ARR method is simple to understand and use.It does not involve complicated computations.
2)Accounting data- The ARR can be readily calculated from the accounting data, unlike in the NPV and IRR methods, no adjustment are required to arrival cash flows of the project.
3) Accounting progitability- The ARR rule incorporate the entire stream in calculating the project’s profitability.