The average accounting return (AAR) is the average project earnings after
taxes and
depreciation, divided by the average
book value of the investment during its life.
Approach to making
capital budgeting decisions involves the average accounting return (AAR). There are many different definitions of the AAR. However, in one form or another, the AAR is always defined as: Some measure of average accounting profit divided by some measure of average accounting value. The specific definition we will use is: Average net income divided by Average book value. It is kinds of decision rule to accept or reject the finance project. For decide to these projects value, it needs cutoff rate. This rate is kind of deadline whether this project produces net income or net loss.
[{{cite book, title=Corporate Finance, url=https://archive.org/details/essentialsofcorp00ross_2, url-access=registration, author1=Ross, Stephen A., author1link=Stephen Ross (economist) , author2=Randolph W. Westerfield , author3=Jeffrey Jaffe , name-list-style=amp , page]
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publisher=McGraw-Hill/Irwin, year=2008, isbn=978-0-07-310590-1
There are three steps to calculating the AAR.
First, determine the average
net income
In business and accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, a ...
of each year of the project's life. Second, determine the average
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
, taking depreciation into account. Third, determine the AAR by dividing the average net income by the average investment. After determine the AAR, compare with target cutoff rate. For example, if AAR determined is 20%, and given cutoff rate is 25%, then this project should be rejected. Because AAR is lower than cutoff rate so this project will not make sufficient net income to cover initial cost. Average accounting return(AAR) does have advantages and disadvantages. Advantages; It is easier to calculate than other capital budgeting decision rules. It only needs net income data and book values of the investment during its life. Another advantage is needed information will usually be available. Disadvantage; it does not take time value of money into account. When we average figures that occur at different times, we are treating the near future and the more distant future in the same way. Therefore, there is no clear indication of profitability. Also the use of an arbitrary benchmark cutoff rate is a disadvantage. The last disadvantage is it is based on accounting net income and book values, not cash flows and market values.
See also
*
Accounting rate of return
References
Financial ratios
Capital budgeting