Explain the concept of accounting rate of return (ARR) and how it is used in capital budgeting.

The accounting rate of return (ARR) is a financial metric used in capital budgeting to evaluate the profitability of an investment project. It measures the average annual profit generated by an investment as a percentage of the initial investment cost.

To calculate the ARR, the average annual profit is divided by the initial investment cost and then multiplied by 100 to express it as a percentage. The formula for ARR is as follows:

ARR = (Average Annual Profit / Initial Investment Cost) * 100

The average annual profit is typically calculated by taking the average of the net cash inflows generated by the investment project over its useful life. The net cash inflows are determined by subtracting the annual operating expenses from the annual revenues or cash inflows.

ARR is used in capital budgeting as a tool to assess the profitability and viability of investment projects. It helps decision-makers compare different investment opportunities and determine which projects are worth pursuing.

The advantages of using ARR in capital budgeting include its simplicity and ease of calculation. It provides a straightforward measure of profitability that can be easily understood by managers and stakeholders. Additionally, ARR considers the entire life of the investment project, which allows for a long-term perspective.

However, there are some limitations to using ARR. Firstly, it does not consider the time value of money, meaning it does not account for the fact that a dollar received in the future is worth less than a dollar received today. Secondly, ARR does not consider the cash flows beyond the payback period, which may lead to biased investment decisions. Lastly, ARR relies on accounting profit, which can be influenced by accounting policies and subjective judgments, potentially leading to inaccurate results.

Despite these limitations, ARR can still be a useful tool in capital budgeting when used in conjunction with other financial metrics. It provides a quick and simple way to assess the profitability of investment projects and can serve as a preliminary screening tool. However, it is important to consider other factors such as the time value of money, cash flow patterns, and qualitative aspects before making final investment decisions.