Definition: The Average Rate of Return or ARR, measures the profitability of the investments on the basis of the information taken from the financial statements rather than the cash flows. It is also called as Accounting Rate of Return
The formula for calculating the average rate of return is:
Average Rate of Return = Average Income / Average Investment over the life of the project
Where, Average Income = Average of post-tax operating profit
Average Investment = (Book value of investment in the beginning + book value of investments at the end) / 2
Accept-Reject Criteria: The projects having the rate of return higher than the minimum desired returns are accepted.
Merits of Average Rate of Return
- It is very simple to calculate and easy to understand
- The measures the profitability of the entire project since it considers the cash flows throughout the life of the project.
- It is based on the accounting information which is readily available and easily understood by the businessmen.
Demerits of Average Rate of Return
- It is based on the accounting information and not on the actual cash flows since the cash flow approach is considered superior to the accounting approach.
- It does not take into consideration, the Time Value of Money.
- It is inadequate to differentiate between the projects on the basis of amounts required for the investment, in case the proposals have the same rate of return.
Thus, this is the only method that uses the firm’s financial data to assess the profitability of the project undertaken and do not rely on the future cash flows.