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Merits and demerits of Accounting Rate of Return (ARR)
The Accounting Rate of Return (ARR) is a widely used technique for investment evaluation. However, like all other measurement processes, it has both merits and demerits.
Merits of Using ARR
Following are some of the merits of using ARR in evaluating an investment −
Simplicity − The ARR method is one of the easiest methods to evaluate an investment. Unlike NPV and IRR methods, it does not involve critical and complex computations. Moreover, being simple to understand, ARR is widely used for audiences who have less knowledge of finance. Simplicity makes ARR the preferred choice of investment evaluation for non-finance managers.
Use of accounting data − Unlike NPV and IRR methods, ARR does not require considering cash flows. ARR can be calculated right from accounting data. As accounting data are readily available, ARR calculation is one of the easiest ways to evaluate an investment. Moreover, as accounting data is a true reflection of a company’s performance, ARR is quite appropriate in evaluating a firm’s performance based on given investments.
Accounting profitability − ARR method consists of the entire stream of income and profitability throughout the project. Therefore, it provides a complete picture of the profitability of an investment project. Using accounting profitability offers the companies the flexibility to focus on more profitable investment options, thereby providing an easy route to evaluate the investments.
Demerits of Using ARR
Here are some of the demerits of using ARR −
Cash flows are ignored − ARR uses profitability as the measure of investment evaluation ignoring the cash flows. As profitability is an incomplete measure of true investment evaluation, ARR is flawed in some cases of investment. Accounting profits are usually based on some arbitrary assumptions, and it may also involve non-cash items. It is therefore inappropriate to rely on ARR completely as a standalone tool to evaluate an investment project.
Time value is ignored − ARR method completely ignores the time value of money which states that a certain amount of money at present is worth more than the same amount of money in the future. The lack of adjustment of the time value of money makes ARR an inappropriate process to evaluate investments.
Arbitrary cut-off − Most of the companies that prefer ARR as an evaluation technique use an arbitrary cut-off yardstick to restrict the projects. Usually, the yardstick is the firm’s current return on its assets which is also known as book value. Due to this, growth companies earning very big rates on the existing assets may reject profitable projects, while smaller companies with fewer returns from assets may choose less profitable projects.
Although ARR is frequently used to evaluate investment projects, its outcomes are often undesirable. Being an unstable way of measuring investments, its use often leads to undesirable allocation of capital in bad projects.
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