University:
Grand Rapids Community College
Course:
Financial and Managerial Accounting: Information for Decisions - John J. Wild
Academic year:

2024
Views:

256

Pages:

2
Author:

stud_ice13

The Accounting Rate of Return (ARR) is a metric used in investment appraisal to assess the profitability of an investment. ARR is calculated by dividing an investment’s annual net income by the average investment amount. ARR helps managers evaluate potential investments by comparing expected profitability against other investment opportunities. ARR Calculation Example: For FasTrac’s $16,000 machine: 1. Calculate the average investment: Average Investment=2Initial Investment+Salvage Value =16,000+02=8,000 2. Calculate ARR: ARR=Annual IncomeAverage Investment×100 FasTrac’s ARR for the machine investment is 25%, which management can use to compare with other potential investments. ARR decisions are often guided by a minimum rate that managers require for any new investment. Example Solution for ARR: Given another investment: • • • Initial Investment = $180,000 Salvage Value = $20,000 Annual Income = $40,000 Using these values: 1. Average Investment = (180,000+20,000)/2=100,000 2. ARR = (40,000/100,000)×100=40% Advantages and Limitations of ARR: Advantages: • Easy to compute and understand. Limitations: • Ignores the time value of money, meaning it does not discount future cash flows. • Does not consider cash flow timing, as it only focuses on annual income, which may not accurately reflect the true profitability if cash flows vary over time. Decision Rule: Managers typically set a minimum ARR as a benchmark. Investments exceeding this minimum are more likely to be approved, as higher ARR percentages indicate higher expected profitability.