There is a lot of confusion between us regarding the concept of ARR. Why we use ARR?
What we derive after calculating ARR?
This won’t be the hectic problem further.
For this first of all we need to know that what ARR. Is?
ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 10%, then it means that the project is expected to earn ten paisa out each rupee invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable.
Note- The ratio does not take into account the concept of time value of money.
There are approximately 10 methods of calculating ARR. In those methods the most commonly 7 methods are used for calculating ARR. Those ares-
ARR = (average income after tax)/ Initial investment
ARR = (average income after tax)/ Average investment
ARR = (average income after tax but before interest) / Initial investment
ARR = (average income after tax but before interest) / Average investment
ARR = (average income before interest and tax)/ Initial investment
ARR = (average income before interest and tax)/ Average investment
ARR = (total income after tax but before depreciation –initial inv.)/ (Initial inv./ 2) * Year
Process of calculating income-
Annual cash flow 1000
Less- Expenses 100
Net annual cash flow 900
Less- depreciation 150
Earning after Dep. OR earnings before tax 750
Less- tax@30% 225
Net earnings after tax and dep. 525
Method of calculating average investment-
Average invt. = (Book value at the beginning of year 1 + book value at the end of useful life)/2
Average investment =net book value of investment at the starting of each year after reducing depreciation/no. of years
Now we can calculate ARR by putting the values in the applicable formula used by that particular firm.