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Thursday, October 1, 2009

Calculation of ARR

Hello friends,

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

OR

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.

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