Capital investment appraisal - ARR (accounting rate of retur...

Learning Outcomes

After reading this article, you will be able to explain what the accounting rate of return (ARR) measures, calculate ARR using accounting profit and investment values, interpret its results for capital investment decisions, and critically assess its advantages and limitations in the context of ACCA exam requirements.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are expected to understand how to evaluate project investments using non-discounted appraisal techniques. This article supports your revision in:

• Defining and explaining the accounting rate of return (ARR) method for capital investment appraisal
• Calculating ARR using profit and investment figures from typical exam scenarios
• Assessing the strengths and weaknesses of ARR as an investment appraisal technique
• Making accept/reject decisions for projects based on ARR calculations and specified hurdle rates

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which statement best describes the accounting rate of return (ARR)?
   1. It compares net profit to average investment
   2. It is based on cash flow only
   3. It always uses discounted cash flows
   4. It ignores depreciation

2. A project has expected average annual accounting profit of $30,000 and will require an initial investment of $200,000 (no residual value). What is its ARR?

3. True or false? ARR considers the time value of money.

4. Name one main limitation and one advantage of using ARR for investment appraisal.

Introduction

Investment appraisal methods help decide whether a capital project is worthwhile. The accounting rate of return (ARR) is a straightforward technique based on profit from financial statements. Unlike discounted cash flow methods, the ARR focuses on accounting profit relative to investment value, making it quick but less precise. In this article, we explain ARR, walk you through typical calculations, and highlight its role—and shortcomings—in supporting business investment decisions.

Key Term: accounting rate of return (ARR)
The ratio of average accounting profit to the value of investment, used to assess the profitability of a capital project.

ACCOUNTING RATE OF RETURN (ARR) METHOD

The ARR is a capital investment appraisal method based on profit earned, not cash flow. It expresses annual accounting profit as a percentage of the capital invested in a project.

Key Features

• Uses profits after depreciation and sometimes after tax.
• Ignores the timing of profits—treats early and late profits equally.
• Simple to understand and calculate.

Key Term: average investment
The average amount of capital invested in a project over its useful life, typically calculated as (initial investment + residual value) / 2.

Calculating ARR

The most common formula for ARR in ACCA FFM is:

$\text{ARR} = \frac{\text{Average annual accounting profit}}{\text{Average investment}} \times 100\%$

Alternatively, some questions use the initial investment in the denominator, so always check the required calculation.

Steps

1. Identify annual accounting profits for each year (typically profit after depreciation but before tax, unless told otherwise).
2. Calculate the average annual profit over the investment period.
3. Work out the average investment:
   (Initial cost + Residual value) / 2
4. Compute ARR as a percentage.

Worked Example 1.1

A company proposes to purchase a machine for $100,000. The machine has no scrap value and will be depreciated straight-line over four years. Expected accounting profits (after depreciation) are $10,000, $18,000, $20,000, $22,000 per year.

Calculate the ARR using average investment.

Answer:

1. Total profit over 4 years: $10,000 + $18,000 + $20,000 + $22,000 = $70,000
2. Average annual profit: $70,000 / 4 = $17,500
3. Average investment: ($100,000 + $0) / 2 = $50,000
4. ARR = $17,500 / $50,000 × 100% = 35%

Worked Example 1.2

A business is considering a project needing $60,000 upfront. After 3 years, it expects a $6,000 residual value. Predicted profits after depreciation are $12,000, $13,000, and $11,000. What is the ARR, rounded to 1 decimal?

Answer:

1. Total profit: $12,000 + $13,000 + $11,000 = $36,000
2. Average profit: $36,000 / 3 = $12,000
3. Average investment: ($60,000 + $6,000) / 2 = $33,000
4. ARR = $12,000 / $33,000 × 100% ≈ 36.4%

DECISION RULES AND PRACTICAL CONSIDERATIONS

A business sets a target ARR (required rate).

• If the project’s ARR meets or exceeds the target, accept.
• If it falls below, reject.

ARR allows ranking of projects: higher ARR is preferred.

Exam Warning

Be alert: ARR may be requested based on either average investment or initial investment. Use the denominator specified in the question. Carefully note which profit figure is required (before or after tax, before or after depreciation). Marks can be lost for using the wrong base or profit figure.

ADVANTAGES AND LIMITATIONS OF ARR

Advantages

• Easy to calculate and explain using data from the financial statements.
• Consistent with accounting measures used in reporting.
• Useful for comparing projects to a required accounting return.

Limitations

Key Term: time value of money
The principle that money available now is worth more than the same amount in the future due to its earning potential.

Key Term: non-cash item
An expense recorded in the profit and loss account that does not involve an actual cash outflow, such as depreciation.

• Ignores the time value of money—late profits are valued the same as early profits.
• Based on accounting profit, not cash flow, so includes non-cash items like depreciation.
• Profit figures can be affected by accounting policies (e.g., depreciation method), making comparison less reliable.
• Does not consider project length directly.

Revision Tip

Always show workings and state your formula in the exam to secure process marks, even if you make a calculation error.

Summary

ARR expresses the average annual profit as a percentage of average (or initial) capital invested. It is simple and uses easily available accounting data, but ignores cash flows and the timing of earnings. While widely used for initial screening, its limitations mean discounted cash flow methods such as NPV are preferred for key decisions.

Key Point Checklist

This article has covered the following key knowledge points:

• Definition and purpose of the accounting rate of return (ARR)
• Calculation method for ARR (average profit and average/initial investment)
• Interpretation of the ARR and project decision criteria
• Main advantages and drawbacks of ARR in investment appraisal
• Comparison of ARR versus discounted cash flow approaches

Key Terms and Concepts

• accounting rate of return (ARR)
• average investment
• time value of money
• non-cash item