Accounting rate of return – What is the accounting rate of return explained with 3 real-life examples

Want to learn more about the Accounting rate of return? In this post, we go through the basics of accounting rate of return.

Accounting rate of return

When someone invests capital in your company, they expect returns. The accounting rate of return measures the expected profitability for capital investment. Businesses, analysts, and accountants use accounting rate of return or ARR capital budgeting. It indicates profitability from simple estimates to evaluate capital projects. We divide the net income from the investment by the total amount invested.

Investors use ARR to decide on the viability and profitability of a capital project before investing. Investors can analyze the risk involved in the investments. Businesses get a snapshot of the potential earnings power of a particular investment. In this blog, we elaborate on what does arr mean?

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What is ARR?

What is ARR?, ARR is an acronym for Accounting Rate of Return.

ARR’s definition is as follows, ARR is the average net income an asset should generate divided by the capital cost. We express ARR as an annual percentage.

The accounting rate of return is an important measure for investors and management. Companies use ARR to decide on the viability of a project or acquisition.

ARR = average annual profit / average investment

Significance of accounting rate of return

The accounting rate of return is a vital metric used by companies before investing. The significance of the accounting rate of return is as follows-

• ARR is easy to calculate and understand. The method considers total profits or savings over the entire project life.
• Analysts factor in depreciation and expenses while appraising a project.
• Companies use ARR to allocate funds. They can compare multiple projects. Companies decide on expansion or acquisition based on figures in accounting rate of return.
• The accounting rate of return gives a clear picture of the profitability of a project.
• ARR considers the profit earned for calculating the rate of return. Accounting profit is easily available from the accounting records.
• ARR helps owners and investors learn about the return on their investment. 
• ARR helps to measure the current performance of the company.

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Accounting rate of return formula

The accounting rate of return formula is as follows:

ARR = average annual profit/ average investment

Where,

Average annual profit = total profit over the investment period/number of years

Average investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2

If you calculate the average rate of return and it equals 10%. It means the annual rate of return is 10 cents for every dollar invested per year.

The ARR should be greater than or equal to the company rate of return for the project to be viable.

How to calculate ARR?

The concept of ARR is simple, but how to calculate ARR? We calculate ARR by dividing the total contract value by the number of years.

1. The first step will be calculating the annual net profits of your investment. Accountants calculate profits after deducting operating expenses, taxes, and interest associated with the project or investment.
2. If the investment is a fixed asset, such as property, you need to calculate the deprecation and expenses. 
3. To get the annual net profits we deduct depreciation expenses from the revenue figures. 
4. In the last step, you divide the annual net profit from the initial cost of the investment. You multiple the net profit by 100 to see the percentage return.

If, you find the arr calculation cumbersome, there are readymade average annual return calculators available online.

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Example of accounting rate of return

ABC Company wants to invest in some capital equipment to replace the old machine. The new machine cost $42 0,000 and would increase the revenue by $200,000. The annual expenses are $50,000. The machine should have a useful life of 12 years and have zero salvage value.

Step 1 Calculate Average Annual Profit
Inflow, year 1-12 (200,000 x12)	$2,400,000
Less Annual expenses (50,000×12)	-$600,000
Less deprecation	-$420,000
Total Profit	$1,380,000
Average Annual Profit  (1,380,000/12)	$115000
Step 2 Calculate Average Annual Investment
Average Investment ((420,000+0) /12)	$210,000
Step 3 Calculate Annual Recurring Revenue
AAR formula	average annual profit/ average investment
Annual Recurring Revenue (115000/210000)	54.76%

This means for every dollar invested, the investment will return a profit of about 54.76 cents.

A capital equipment costs $350,000 would increase the annual revenue by $100,000. The company’s expenses of the company are $10,000. The equipment has life of twenty years with no salvage value. 

Step 1 Calculate Average Annual Profit
Inflow, year	$100,000
Less Annual expenses (10,000)	-$10,000
Less deprecation  (350,000/20)	-$17500
Total Profit	$72500
Average Investment	$350000
Step 3 Calculate Annual Recurring Revenue
AAR formula	average annual profit/ average investment
Annual Recurring Revenue (72,500 / 350,000 )x100	20.71%

This means for every dollar invested, the investment will return a profit of about 20.71 cents.

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How to calculate ARR in excel?

Excel has long been used for accounting purposes.  To keep track of ARR you can use annual rate of return excel. Here are the steps you can use to calculate ARR

Let us take the example of a company that has recently invested $60 million in setting up a new plant. The company expects to generate revenue of $15 million in the first year while operating expense is likely to be 30% of the revenue. The asset is expected to be scrapped after 10 years of estimated life with zero salvage value. Calculate the accounting rate of return for the investment based on the given information.

	A	B
5	Particulars	Amount (in millions)
6	Revenue	$15
7	Initial investment	$60
8	Estimated life of Asset	$10
	Operating Expenses is calculated as
	Operating Expenses	30% x Revenue
9	Operating Expenses Formula	30% *B6 = 30/100*(15)
10	Operating Expenses	$4.5
11	Depreciation is calculated using the formula
12	Depreciation	(Initial Investment –Salvage Value)/Estimated  Value
13	Depreciation Formula	(B7-0)/B8
14	Depreciation	$6
15	Incremental Accounting Income is calculated  using formula
16	Incremental Accounting Income	Revenue – Operating Expenses –Depreciation
17	Incremental Accounting Income Formula	= B6-B10-B14
18	Incremental Accounting Income	$4.5
19	Accounting Rate of Return is calculated using the formula
20	Accounting Rate of Return	Incremental Accounting Income/Initial Invesment*100
21	Accounting Rate of Return Formula	=B18/B7*100
22	Accounting Rate of Return	7.5%

This means for every dollar invested, the investment will return a profit of about 7.5 cents.

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What is required rate of return formula?

Investors expect return on investment when they invest in a company.  The required rate of return is the minimum return of investment an investor expects for investing the company stock. There are two methods to calculate the required rate return formula

Capital Assets Pricing Model (CAPM) method

RRR = RRR = rf + ß(rm – rf)

Where

• RRR – required rate of return
• rf – risk-free rate
• ß – beta coefficient of an investment
• rm – return of a market

Weighted Average Cost of Capital (WACC)

RRR = wDrD(1 – t) + were

 Where:

• wD – weight of debt
• rD – cost of debt
• t – corporate tax rate
• we – weight of equity
• re – cost of equity

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What is simple rate of return?

Simple rate of return is an estimated return of investment. We calculate it by calculating profit before taxes and interest. The simple rate of return is easy to calculate. The drawback of simple rate of return is that it does not focus on cash flow but on net operating income.  

We estimate the revenue that will be generated from the proposed investment and deduct projected expenses from the project. The simple rate of return formula

Simple rate of return = (Incremental revenues − Incremental expenses, including depreciation

= Incremental net operating income) / Initial investment]

Simple rate of return = (Cost savings − Depreciation on new equipment) / Initial investment*

*the investment should be reduced by any salvage from the sale of old equipment.

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What is expected rate of return formula?

The expected return definition is as follows is the profit or loss that an investor expects on an investment. Expected rate of return or return on investment is calculated by multiplying the potential outcomes with the chances of the event occurring and then adding the results.

Investments are inherently is a risky the return on investment help companies and investors consider the risk factors linked with the investment. The rate of return helps investment companies develop model portfolio. Those who trade in the stock market examine stock history and market trends to calculate expected rate of return. 

The expected rate of return formula =  Sum (Returni x Probabilityi)

ER= R1P1+ R2P2 + R3P3 +…..+RnPn

What is annual rate of return formula?

The annual rate of return or yearly rate of return or nominal annual rate is the amount earned on a fund during the year. The annualized rate of return works by calculating the money gained or lost at the end of the year dividing it by the initial investment at the beginning of the year. 

The annual rate of return formula

Annual rate of return =(BYPEYP−BYP​)×100

where:

EYP=End of year price

BYP=Beginning of year price

Investments in different firms are difficult to compare. Since the annual rate of return calculates the return of return every year, we can compare different types of investments and judge which investments gave the best returns.  A major drawback of the nominal annual rate is it does not consider the potential of the investment compounding over a period.

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What is ARR stock dividend?

Companies use ARR stock dividend to distribute  wealth to the shareholders.  The dividend is made company shares rather than cash. Stock dividend are made in lieu of cash,  when company is low on liquid cash. The company can reward its investors without reducing its cash reserves, but can reduce the earning per share.

Investors are paid a fraction of their existing shares. Stock dividend is not taxed till the shares are sold. When companies issue the shares it dilutes the value of existing shares because of the increase in the number of shares.

What is rate of return on asset?

Return of assets (ROA) measures the profitability of a business in a relationship with its total assets. Investors, managers or analyst use the ROA to find out how the company are using  its assets to generate revenue.  ROA is displayed as percentage. Companies try to achieve higher return on assets.

Businesses operate for profits while using all resources available to them. Stakeholders and analyst calculate the ratio of profit to resources available to find out feasibility of a project. You can use ROA to find out how quickly you will get returns on your investment.

Return on Assets formula =Total Assets/Net Income​

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What is accrual accounting rate of return?

Accrual accounting rate of return is the percentage of rate of return on an investment or assets, for the initial investment. The ARR formula divides the average revenue of the company by its initial investment cost.  You can derive the ratio or return on investment over the life of the assets or related to the project. 

This accounting rate of return calculates the profit related to the project using accrual and non-cash expenses and depreciation. The accrual accounting rate of return formula is as follows –

Accrual accounting rate of return = Average annual accounting profit/ Initial investment.

What is ARR dividend?

ARR dividend is the total expected dividend payment from an investment fund or portfolio expressed annually plus any non-recurring dividend received in the period. Companies may choose to offer their subscribers a fixed or adjustable dividend. Dividend rate and dividend yield are used interchangeably. 

ARR dividend is a financial ratio that shows how much the company pays out in dividends each year relative to its stock price. Companies should aim to generate a healthy dividend to pay out dividend.

You can use dividend rate to estimate the dividend only return on investment. Dividend amount is unchanged, the dividend rate improves if a company stock prices falls. The converse is also true the dividend rate falls if the company stock prices rises.