15.6 Non-discounting methods: accounting rate of return (ARR)

Question 1

What is another name for the accounting rate of return (ARR) method of project appraisal?

Answer 1

Return on Capital Employed (ROCE)

Question 2

What is the principle of the accounting rate of return (ARR) method of project appraisal

Answer 2

Using accounting profits to estimate the average rate of return that the project is expected to yield over the life of the investment.

Question 3

How is the accounting rate of return (ARR) method of project appraisal measured? (equation)

Answer 3

[Average annual profits / average capital cost] x 100

i.e. annual profits as a percentage of the initial cost

Question 4

What is the decision rule for the accounting rate of return (ARR) method of project appraisal?

Answer 4

The project is undertaken if the ARR is equal to or greater than the target rate of return.

Question 5

What are the advantages of the accounting rate of return (ARR) method of project appraisal?

Answer 5

• simple to calculate
• uses profit (which most managers will have an understanding of)
• focuses on profitability for the whole project period
• easy to compare with other projects as it links to other accounting methods

Question 6

What are the disadvantages of the accounting rate of return (ARR) method of project appraisal?

Answer 6

• ignores some factors including the life length of the project (which may affect risk)
• method is based on profits, which may vary
• does not account for the time value of money
• can be calculated in a few different ways, which may affect comparability