IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 5. What is an ARR and how is this to be calculated?

Ans. ACCOUNTING RATE OF RETURN

The Accounting Rate of Return also called the Average Rate of Return (ARR) is the average of the rate of return for different years for the whole life of an asset. It is a ratio between the Net Profit After Tax and the amount of initial investment made in the project.

ARR= Average PAT / Initial Investment

Another view about ARR is that since we take average of the PAT for calculating ARR we should also use average level of investment for the project. In such a situation the equation for calculating ARR should be modified as follows.

ARR= Average Profit After Tax / Average Investment

Acceptance & Ranking Rule :- When we adopt ARR as the decision criteria, then the acceptance rule is that the calculated ARR should be greater than some specified rate. We will reject those proposals which have an ARR lower than this specified rate. So far as ranking of projects is concerned, the project with a higher ARR should be ranked higher than other project which has a lower ARR.

Evaluation of ARR Method :- The ARR method is a relatively simple method involving the calculation of averages. It is also based on easily understood accounting information like EBIT/PAT, depreciation, investment etc. However, when it is evaluated for its suitability as a investment criteria for making long term investment decisions, we find it deficient in several respects. Firstly, it is ill defined; we do not know whether to use EBIT or PAT; Initial Investment or Average Investment. Each variable will give different values of ARR. Moreover, accounting information itself is not very certain and subject to great manipulation; Thirdly the average of income, whether EBIT or PAT ignores time value of money and hence not suitable for scientific decision making, and lastly the bench mark rate, against which the calculated ARR will be compared is arbitrary and there is no scientific basis for deciding it.