The average accounting rate of return (AAR) can be defined as

 AAR = Average Net IncomeAverage Book Value

 To understand this measure of return, we will use a numerical example. Assume a company invests $200,000 in a project that is depreciated straight-line over a five-year life to a zero salvage value. Sales revenues and cash operating expenses for each year are as shown in below table. The table also shows the annual income taxes (at a 40 percent tax rate) and the net income.

 

Year 1

Year 2

Year 3

Year 4

Year 5

Sales

100,000

150,000

240,000

130,000

80,000

Cash Expenses

50,000

70,000

120,000

60,000

50,000

Depreciation

40,000

40,000

40,000

40,000

40,000

Earnings before Taxes

10,000

40,000

80,000

30,000

(10,000)

Tax @ 40%

4,000

16,000

32,000

12,000

(4,000)

Net Income

6,000

24,000

48,000

18,000

(6,000)

 Negative taxes occur in Year 5 because the earnings before taxes of –$10,000 can be deducted against earnings on other projects, thus reducing the tax bill by $4,000.

 For the five-year period, the average net income is $18,000. The initial book value is $200,000, declining by $40,000 per year until the final book value is $0. The average book value for this asset is ($200,000 –$0) / 2 = $100,000. The average accounting rate of return is

 AAR = Average Net IncomeAverage Book Value = 18,000100,000 = 18%

The advantages of the AAR are that it is easy to understand and easy to calculate. The AAR has some important disadvantages, however. Unlike the other capital budgeting criteria discussed here, the AAR is based on accounting numbers and not based on cash flows. This is an important conceptual and practical limitation. The AAR also does not account for the time value of money, and there is no conceptually sound cutoff for the AAR that distinguishes between profitable and unprofitable investments. The AAR is frequently calculated in different ways, so the analyst should verify the formula behind any AAR numbers that are supplied by someone else. Analysts should know the AAR and its potential limitations in practice, but they should rely on more economically sound methods like the NPV and IRR.

 

Average Accounting Rate of Return

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Family Budget Planner Spreadsheet
Average Accounting Rate of Return
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