The Average Rate of Return (ARR), or the Accounting Rate of Return (AAR), is a commonly used approach in capital budgeting. ARR measures an investment's profitability by comparing the average accounting profit to the average accounting value.
For instance, a retail company considering a $300,000 investment in new inventory management software could use ARR to estimate profitability. If the software is expected to generate an additional $60,000 in annual profits over five years, ARR would give the company a way to gauge the return on this investment.
This metric provides a straightforward way to assess financial performance by calculating the annual return as a percentage of the investment's average book value. While ARR is appealing for its simplicity, it does not account for the time value of money or consider the risks associated with an investment. Despite these limitations, ARR remains applicable for quick, initial investment assessments in capital budgeting.
From Chapter 7:
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