Accounting Rate of Return (ARR) is the only capital budgeting technique that uses profits rather than cash flows to evaluate the viability of a project. ARR takes into consideration various expenses that are incurred by the asset every year, including depreciation.

Accounting Rate of Return is important for businesses because it can be used to compare several projects or investments to determine the expected rate of return for each profit and decide on the best project. Usually, the project with the highest rate of return is chosen because it gives the company more profits and helps them to grow. The formula for calculating ARR is shown below:

ARR = (Average Annual Profit after Tax ÷ Average Cost of Investment) × 100

Where:

*Average Investment = (Book Value at 1st year + Book Value at End of Useful Life)/2**Average Annual Profit = Total profit over Investment Period / Number of Years*

The outcome of dividing annual profit by cost of capital is multiplied by 100 to get the percentage rate of return.

**Steps Used to Calculate the Accounting Rate of Return**

** Step 1**: Calculate the annual net profit of the company – that is, net profit after tax. This includes all revenues minus all annual expenses, including profits, financial costs and depreciation.

** Step 2:** For a fixed asset such as property, plant and equipment (PPE), subtract the depreciation expense from the annual revenue to get the annual net profit.

** Step 3**: Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.

*Example 7.4: Simple Calculation of ARR*

Chepkonga Traders Ltd wants to implement a project that requires an initial investment capital of $250,000 and is expected to generate revenue of $70,000 annually for the next 5 years.

*Solution: *

ARR = (annual revenue/initial cost) × 100

= ($70,000/$250,000) × 100

= 28%

*Example 7.5: Calculating ARR for a Project with Varying Annual Returns*

Juma Entertainment Company is considering to buy equipment at an initial cost of $50 million. Assume the useful life of the equipment is 5 years and has nil residual value. The earnings before depreciation and tax are provided below:

Year |
Earnings ($ ‘000) |

1 | 12000 |

2 | 15000 |

3 | 18000 |

4 | 20000 |

5 | 22000 |

Assuming the corporate tax rate is 30% and the depreciation is on straight line basis. Calculate the ARR of the investment.

*Solution:*

** Step 1**: Calculate Depreciation

Depreciation = (total cost – residual value) ÷ number of years

= (50 million – 0) ÷ 5 = 10 million

Depreciation for every year is $10 million.

** Step 2:** Calculate Average Income

Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |

Earnings before depreciation and tax | 12000 | 15000 | 18000 | 20000 | 22000 |

Depreciation | (10000) | (10000) | (10000) | (10000) | (10000) |

Earnings after Depreciation | 2000 | 5000 | 8000 | 10000 | 12000 |

Tax @ 30% | (600) | (1500) | (2400) | (3000) | (3600) |

Profit after tax | 1400 | 3500 | 5600 | 7000 | 8400 |

**NB: **

- The values are in thousands (‘000’)
- Tax is calculated as 30% of earnings after tax, e.g. first year tax = 30% × 2000 = 600.
- Tax and depreciation figures are recorded with brackets to show that they are negative values.
- Profit after tax is obtained by subtracting tax amounts from the earnings after depreciation

Calculate the average investment by adding all the annual net income after tax and divide by the total economic life of the investment

Average income = (1400+3500+5600+7000+8400)/5 = 5,180

Remember this was in thousands (‘000’), so:

Average income = *5,180,000*

** Step 3:** Calculate ARR by dividing the average income by the average investment costs. Average investment cost is obtained by adding the initial cost of the equipment with the residual value and dividing the answer by 2. Residual value for the above equipment is 0, so the average cost of investment is: (50 million – 0)/2 = 25 million.

ARR = (5,180,000/25,000,000) × 100

= *20.72%*

*Decision Criteria:*

If the projects are mutually exclusive the project with the highest ARR is accepted. If projects are independent, they should be ranked from the one with the highest ARR which should come first to the one with the lowest as the last.

If the firm has a minimum acceptable ARR, then the decision will be based on the project with a higher ARR as per their preferred rate.