Accounting Rate of Return (ARR)

The accounting rate of return (ARR) is a profitability ratio that measures the net income generated by an investment relative to its initial cost. It is calculated by dividing the average net income over a period of time by the initial investment.

The ARR is a simple and easy-to-understand metric that can be used to compare the profitability of different investments. However, it has several limitations, including the fact that it does not take into account the time value of money and that it does not consider the risk of the investment.

Despite its limitations, the ARR can be a useful tool for making investment decisions. It is important to be aware of the limitations of the ARR when using it to evaluate investments.

Here is a more detailed explanation of how to calculate the ARR:

1. First, you need to determine the average net income over the period of time you are considering. This can be done by adding up the net income for each year and dividing by the number of years.
2. Next, you need to divide the average net income by the initial investment. This will give you the ARR.

For example, if you invest $100,000 in a project and the project generates $10,000 in net income each year for five years, the average net income is $10,000 / year. The ARR is $10,000 / year / $100,000 = 10%.

The ARR is a useful tool for comparing the profitability of different investments. However, it is important to be aware of its limitations when using it to make investment decisions.

Here are some of the limitations of the ARR:

* The ARR does not take into account the time value of money. This means that it does not consider the fact that a dollar today is worth more than a dollar in the future.
* The ARR does not consider the risk of the investment. This means that it does not take into account the possibility that the investment may not generate any net income or that it may lose money.
* The ARR is only based on historical data. This means that it does not take into account the possibility that the future performance of the investment may be different from the past.

Despite its limitations, the ARR can be a useful tool for making investment decisions. However, it is important to be aware of its limitations when using it to evaluate investments.