The average accounting return (AAR) is the average project earnings after
taxes
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, o ...
and
depreciation
In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
, divided by the average
book value
In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. T ...
of the investment during its life.
Approach to making
capital budgeting
Capital budgeting in corporate finance is the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development projects ...
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 of each year of the project's life. Second, determine the average
investment, 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
Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net i ...
References
Financial ratios
Capital budgeting