This method is designated to consider the relative profitability of different capital investment proposals as the basis for ranking them – the fact neglected by the payout period technique. Since this method uses accounting rate of return. It is sometimes described as the financial statement method. Rate of return is calculated by dividing earnings by capital invested. The numerator here means earning can be interpreted in a number of ways. It might mean income after taxes and depreciation, income before taxes and depreciation, or income after taxes but before depreciation.
ARR =Average PAT/Initial Investment
Normally business firm determine rate of return. So accept the proposal if : ARR > Minimum rate of return (cut of rate), and
Reject the project if : ARR < Minimum rate of return ( cut off rate)
In case of more than one project, Where a choice has to be made, the different project may be ranked in descending or ascending order of their rate of return. Project below the minimum rate will be dropped. In case of project yielding rate of return higher than minimum rate, it is obvious that project yielding a higher rate of return will be preferred to all.
So far as ranking of projects is considered, the project with a higher ARR should be ranked higher than other project which has a lower ARR.
Advantages Accounting Rate of Return
• Earning over the entire life of a project are considered.
• This method is easy to understand, simple to follow.
• It is based on accounting concept of profit, which are easily calculated for financial data.
Disadvantages Accounting Rate of Return
• Like the payback technique, the average return on investment method also ignore the time value of funds. Consideration to distribution of earnings over time is important. It is to be accepted that current income is more valuable than income received at a later date.
• The method ignores the shrinkage of original investment through the process of charging depreciation allowances against earnings. Even the assumption of regular recovery of capital over time as implied in average investment approach is not well founded.
• The average rate of return on original investment approach cannot be applied to a situation where part of the investment is to be made after the beginning of the project.
If the project life is not long, than the method can be used to have a rough assessment of the internal rate of return. The present method is generally used as a supplementary tool only.