ACCOUNTING RATE OF RETURN (ARR)
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Average annual accounting profit from an investment divided by its average investment.
Summary
The Accounting Rate of Return (ARR) is a simple financial metric used to evaluate the profitability of an investment or project. It calculates what percentage return you can expect each year by dividing the average annual profit (after depreciation but before interest and taxes) by the average amount invested. Unlike other investment appraisal methods, ARR uses accounting profits rather than cash flows, making it easier to understand but potentially less accurate for decision-making. It's expressed as a percentage and helps managers compare different investment opportunities.
Usage Context
ARR is crucial when studying capital investment appraisal and comparing different investment projects. Students encounter this when learning about financial decision-making, performance measurement, and evaluating the profitability of long-term investments. It's often taught alongside other appraisal methods to show different approaches to investment analysis.
Common Confusions
- Confusing accounting profit with cash flow - ARR uses profit, not cash movements
- Using initial investment instead of average investment in the denominator
- Mixing up ARR with IRR (Internal Rate of Return) - they're completely different calculations
- Forgetting to account for depreciation when calculating annual profit
- Not understanding why ARR doesn't consider the time value of money
