Advantages and Disadvantages of Accounting Rate of Return (ARR)

The accounting rate of return (ARR) is an investment appraisal technique which is used to measure the percentage rate of return expected from an investment or asset compared to the initial cost of the investment. This capital budgeting technique can be calculated by dividing the average net income that an asset is expected to generate by the average cost of capital. ARR uses a formula that compares the net income of an asset with the initial cost of acquiring that asset. It 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.

There are several advantages and disadvantages of the Accounting Rate of Return. Investors should consider these pros and cons to determine whether they should use this capital budgeting technique to make investment decisions.

Advantages

The main advantages of using the Accounting Rate of Return to assess the viability of an investment project are:

  • Accounting Rate of Return (ARR) is simple and straightforward. One of the easiest investment appraisal techniques.
  • ARR is also easy to calculate and easy to use; its advantage is that it can be calculated and interpreted easily.
  • It is the only investment appraisal method that measures profitability of the firm
  • Another advantage of this capital budgeting technique is that the accounting information used is readily available from the financial statements.
  • All the returns in the entire life of the project are used in determining the project’s profitability.

Disadvantages

ARR also has some disadvantages such as:

  • One of disadvantages of ARR is that it fails to take account of the project life or the timing of cash flows and time value of money within that life
  • The Accounting Rate of Return also ignores time value of money
  • It uses accounting profit, hence subject to various accounting conventions
  • Another disadvantage is that the Accounting Rate of Return does not allow for the fact that profits can be reinvested
  • There is no definite investment signal. The decision to invest or not remains subjective in view of the lack of objectively set target ARR
  • Like all rate of return measures, the Accounting Rate of Return is not a measurement of absolute gain in wealth for the business owners
  • The ARR can be expressed in a variety of ways and is therefore susceptible to manipulation

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