This method is also called Accounting Rate of Return Method. This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return. It can be calculated as:-

ARR = ___________________________X100

Total of after tax profit of all the year

Average Annual Profit= ___________________________

Average Investment = ________________________________

or Original Investment – Salvage Value

If working Capital is also required in the initial year of the project, the average investment will be= Net working Capital + Salvage value + ½ (initial cost of Machine- Salvage Value).

In another method instead of average investment original cost is used.

In this method, to evaluate the project all those projects are accepted on which average rate of return is more than the predetermined rate. Thus, the project is given more significant on which the average rate of return is the highest.

Acceptance Rule

Accept if ARR > minimum rate.

Accept if ARR <>

Merits

1). Easy to understand. Necessary informations to calculate average rate of return are available easy.

2). This method takes into account all the profits during the life time of the project, whereas pay back period ignores the profits accruing after the pay back period

3). Give more weightage to future receipts.

4). Easy to understand and calculate.

5). Uses accounting data with which executives are familiar.

Demerits

1). Ignore the time value of money.

2). Does not use cash flow.

3). No objective way to determine the minimum acceptable rate of return.

4). This method does not account for the profits arising on sale of profit on old machinery on replacement.

5). ARR method does not consider the size of investment for each project. It may be time that the competing ARR of two projects may be the same but they may require different average investments. It becomes difficult for the management to decide which project should be implemented.