Accounting rate of return

# Accounting rate of return

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Encyclopedia
Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting
Capital budgeting
Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing...

. The ratio does not take into account the concept of time value of money
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

## Basic formulae

where

• Internal rate of return
Internal rate of return
The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...

• Net present value
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

• Payback period
Payback period
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a \$1000 investment which returned \$500 per year would have a two year payback period. The time value of money is not taken into account...

• Rate of return on a portfolio
Rate of return on a portfolio
The rate of return on a portfolio is "a weighted average of the rates of return on the various assets with the weights being equal to the fractions of the individual's wealth held in these assets" This equates to an average of the average returns on a portfolio taking into account what portion of...