Economics Capital Budgeting Questions Medium
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 following steps are typically followed:
1. Determine the average annual profit: This is calculated by subtracting the annual expenses (including depreciation) from the annual revenue generated by the investment project.
2. Calculate the average investment: This is the average of the initial investment cost and the salvage value (if any) at the end of the project's useful life. The salvage value represents the estimated value of the investment at the end of its useful life.
3. Divide the average annual profit by the average investment: This will give you the ARR as a decimal.
4. Multiply the ARR by 100 to convert it into a percentage: This will give you the ARR as a percentage.
The formula for calculating the ARR can be expressed as:
ARR = (Average Annual Profit / Average Investment) x 100
The ARR is then compared to a predetermined minimum acceptable rate of return (MARR) or a company's required rate of return. If the ARR is higher than the MARR, the investment project is considered acceptable. Conversely, if the ARR is lower than the MARR, the project may be rejected.
It is important to note that the ARR has some limitations as a capital budgeting tool. It does not consider the time value of money, does not account for cash flows beyond the payback period, and does not provide a measure of the project's risk. Therefore, it is often used in conjunction with other capital budgeting techniques to make more informed investment decisions.