INVESTMENT APPRAISAL
ACCOUNTING RATE OF RETURN
THE ACCOUNTING RATE OF RETURN
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The accounting rate of return looks at the average accounting
profit an investment generates and expresses it as a % of the
average book value of the investment over its life.
Accounting Rate of Return 
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This is then compared to a target rate of return
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Accept if higher than target
Reject if lower than target
Cash flows are adjusted to accounting profits
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Average profit
 100%
Average book value of investment
Profit is not the same as money in the bank. It is a figure that is based
on the rules of accounting
Average book value of the asset over its life is the average
value at which it is recorded in the firm’s accounts
EXAMPLE: ACCOUNTING RATE OF RETURN
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A firm is considering purchasing a new piece of equipment
costing €200,000. The machine is expected to have a useful
economic life of 4 years, after which it will be sold at its
residual value. The firm is expected to generate the
following cash flows over each of the next four years:
Year
CF

1
€65,000
2
€75,000
3
€80,000
4
€65,000
If the machine is depreciated at a rate of 30% per annum
using the reducing balance method, calculate the
accounting rate of return for the machine.
EXAMPLE: ACCOUNTING RATE OF RETURN
Year
NBV Start
Depreciation NBV End
Cash Flow
Profit
1
200,000
60,000
140,000
65,000
5,000
2
140,000
42,000
98,000
75,000
33,000
3
98,000
29,400
68,600
80,000
50,600
4
68,600
20,580
48,020
65,000
44,420
NBV = Net Book Value (cost – accumulated depreciation)
Average Book Value = (200,000 + 140,000 + 98,000 + 68,600 + 48,020) / 5 = 110,924
Average profit = (5,000 + 33,000 + 50,600 + 44,420)/ 4 = 33,255
Accounting rate of return = 33,255 / 110,924 = 0.2998 or 29.98%
ADVANTAGES OF ARR
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As it is based on profits, non-financial managers
should find it easy to understand i.e. the more
profit the better!
Profits are important, as investors base
investment decisions on the profits firms report.
Projects that maximise profits should help
attract investors
It is useful as a starting point for screening
projects i.e. it can be used to quickly weed out
projects that are unsuitable
DISADVANTAGES OF ARR
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Accounting profits are not actual sums of money. A project
could have high profits but the cash flows may be lower
It does not take the time value of money into account i.e. it
fails to recognise that cash received earlier can be
reinvested and so is worth more than cash received later
It ignores the size of the investment.
Is it better to earn 20% on €100,000 investment, or 19% on
€200,000 investment???
 What if the project doesn’t work out? Is it better to risk
€100,000 rather than €200,000??
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It ignores the duration of the project
Is it better to earn 20% for 4 years or 19% for 5 years??
 A longer project may have a higher ARR, but longer projects
are riskier as the forecasted figures are less certain
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