Calculate Accounting Rate of Return in Excel

Accounting Rate of Return (ARR) is a financial metric that measures the profitability of an investment by considering both the initial investment and the time value of money. It's commonly used in accounting and financial analysis to evaluate the efficiency of capital investments.

What is Accounting Rate of Return?

The Accounting Rate of Return is a financial metric that measures the profitability of an investment by considering both the initial investment and the time value of money. It's commonly used in accounting and financial analysis to evaluate the efficiency of capital investments.

Unlike the Internal Rate of Return (IRR), which only considers cash flows, ARR accounts for the cost of capital and the time period of the investment. This makes it particularly useful for comparing investments of different durations and risk levels.

ARR is often expressed as an annual percentage and is used to assess whether an investment is generating sufficient returns to justify its cost.

How to Calculate Accounting Rate of Return

Calculating the Accounting Rate of Return involves several steps that account for both the initial investment and the time value of money. Here's a step-by-step guide:

Determine the initial investment amount.
Calculate the total cash inflows over the investment period.
Account for the time value of money by discounting future cash flows to their present value.
Subtract the initial investment from the present value of cash inflows.
Divide the result by the initial investment to get the ARR.

This process ensures that the rate of return reflects both the profitability of the investment and the opportunity cost of capital.

Accounting Rate of Return Formula

The formula for calculating Accounting Rate of Return is:

ARR = [(PV of Cash Inflows - Initial Investment) / Initial Investment] × 100

Where:

PV of Cash Inflows = Present Value of all cash inflows
Initial Investment = The initial amount invested

The present value of cash inflows is calculated using the discount rate, which typically represents the cost of capital or required rate of return.

Accounting Rate of Return in Excel

Calculating Accounting Rate of Return in Excel involves using financial functions to account for the time value of money. Here's how to do it:

Enter the initial investment amount in cell A1.
List the cash inflows in cells B1 to Bn (one for each period).
Enter the discount rate in cell C1.
Use the NPV function to calculate the present value of cash inflows: =NPV(C1, B1:Bn)
Calculate the ARR using the formula: =((NPV(C1, B1:Bn)-A1)/A1)*100

This Excel approach ensures accurate calculation of the Accounting Rate of Return while accounting for the time value of money.

Example Calculation

Let's look at an example to illustrate how to calculate Accounting Rate of Return:

Year	Cash Inflow
0	-10,000
1	3,000
2	4,000
3	5,000

With an initial investment of $10,000 and a discount rate of 10%, the calculation would be:

PV of Cash Inflows = NPV(10%, 3000, 4000, 5000) = $9,900

ARR = [(9,900 - 10,000) / 10,000] × 100 = -1%

This example shows that the investment is not generating a positive return after accounting for the time value of money.

FAQ

What is the difference between Accounting Rate of Return and Internal Rate of Return?

Accounting Rate of Return accounts for the time value of money by discounting future cash flows, while Internal Rate of Return only considers cash flows without discounting. ARR is more comprehensive for comparing investments of different durations.

How do I choose the right discount rate for ARR calculation?

The discount rate should reflect the cost of capital or the required rate of return for the investment. It's typically based on the organization's weighted average cost of capital (WACC) or the opportunity cost of funds.

Can Accounting Rate of Return be negative?

Yes, Accounting Rate of Return can be negative if the present value of cash inflows is less than the initial investment, indicating the investment is not profitable after accounting for the time value of money.