Accounting rate of return(ARR) is one of the most commonly used capital budgeting techniques. It measures the rate of return on the initial investment based on accounting income. When evaluating a new project or investment, it’s important to understand both the strengths and weaknesses of ARR. This article will provide an in-depth analysis on when ARR works well as an investment analysis tool and when it falls short compared to more sophisticated capital budgeting methods like net present value(NPV) and internal rate of return(IRR). We’ll also look at some real world examples to illustrate the proper application of ARR.
ARR has a close link to return on capital employed, enhancing credibility
One of the main strengths of the ARR method is its close link to return on capital employed(ROCE), a common financial ratio used in evaluating business performance. Both metrics rely on familiar accounting income figures rather than complex time value of money calculations. This makes ARR easy for both accountants and general managers to understand and interpret. The use of accounting rate of return also enhances credibility and adoption since managers are already familiar with ROCE as a key financial metric. ARR provides a project assessment result in easy-to-understand percentage terms, similar to ROCE.
ARR ignores the time value of money and cash flow timing
However, one of the biggest limitations of ARR is that it does not properly account for the time value of money, which is a key component in capital budgeting and investment analysis. ARR simply divides average accounting income by the initial investment, treating all cash flows equally over the life of a project. This fails to reflect that cash flows generated earlier are actually worth more than cash flows generated later on. Methods like NPV explicitly factor in the time value of money by discounting future cash flows back to the present. This allows for a more apples-to-apples comparison of projects with different cash flow timings.
ARR has weaknesses in ranking competing capital investments
Another weakness of ARR emerges when trying to rank competing capital investment projects. ARR cannot properly rank projects of different sizes or time horizons. A project with higher ARR may actually have a lower NPV than a competing project with lower ARR. NPV analysis accounts for total magnitude and timing of cash flows to provide a better ranking of mutually exclusive projects. IRR also factors in project scale and duration for ranking.
NPV or IRR are better alternatives for capital budgeting
In summary, ARR has some merits in terms of simplicity and familiarity for managers. However, for rigorous capital budgeting analysis, methods like NPV and IRR are generally recommended over ARR because they explicitly incorporate the time value of money and better rank competing investments. ARR is best suited for quick, initial screenings of potential projects. NPV or IRR provide more robust analysis for final capital budgeting decision making.
Accounting rate of return has strengths in terms of easy understanding but also limitations around timing of cash flows. NPV and IRR techniques are superior for formal capital budgeting analysis and investment decision making.