Understanding the Accounting Rate of Return Formula with Salvage Value

If a company is looking to project the expected return on an investment, it can use the accounting rate of return (ARR). ARR is expressed as a percentage and is a formula that measures the net profit or return expected on an investment compared to the initial cost.

Calculating Accounting Rate of Return

The formula for calculating ARR takes into account the expected net income and the initial cost of the investment. It is calculated by dividing the expected net income by the initial cost and multiplying the result by 100.

ARR = (Expected Net Income / Initial Cost) x 100

ARR Pros and Cons

Like any financial metric, the accounting rate of return has its pros and cons. Some of the advantages of using ARR include:

• Easy to calculate and understand
• Provides a percentage-based measure of return
• Useful for comparing different investment options

However, there are also disadvantages to using ARR, such as:

• Does not consider the time value of money
• Does not account for cash flows over the life of the investment
• Relies on estimated figures, which may not be accurate

Bottom Line

The accounting rate of return can be a useful tool for companies looking to evaluate the profitability of an investment. However, it is important to consider the limitations of ARR and use it in conjunction with other financial metrics to make well-informed investment decisions.

Tips for Evaluating Capital Investments

When using the accounting rate of return formula with salvage value, there are a few tips to keep in mind:

• Ensure that the expected net income and initial cost are accurately estimated
• Consider the salvage value of the investment at the end of its useful life
• Compare the ARR of different investment options to identify the most profitable one

By following these tips and considering the limitations of ARR, companies can make more informed decisions when evaluating capital investments.