Thursday, March 20, 2008

Calculate Average Accounting Return

A toilet manufacturer is considering building a new production plant in a new town. It will require an initial capital investment of $12 million and the plant will be depreciated on a straight-line basis over the next four years of its use. The new project will generate incremental net income of $900,000, $1,350,000, $1,200,000 and $1,950,000 over each of the next four years for the company. What is the average accounting return (AAR) for this project?


How to solve for Average Accounting Rate of Return?

The AAR (Average Accounting Rate of Return) measures the average accounting profit earned on the average amount of capital invested over a project's life span for a company. Assets are normally depreciated on a straight-line basis with the method. Therefore the average book value formula is solved by dividing the initial investment by the length of the project's expected life:

Average book value of assets: $12,000,000/2 = $6,000,000

This assumes a beginning value of $12,000,000 and an ending value of $0. Hence, they have an average value of $6,000,000.

Next you must calculate average net income over the period:

($900,000+$1,350,000+$1,200,000+$1,950,000)/4 = $1,350,000

The Average Accounting Return (AAR) Equation is:

AAR= Average Net Income/Average Book Value

= $1,350,000/$6,000,000
= .225 or 22.5%

Using the Average Accounting Rate of Return (AAR) formula and equation is good capital budgeting tool because managers can compare it to objective benchmarks and past perfomance.

External Links:
Evaluating Business Investments
What is Residual Income?
What is Working Capital Management?

5 comments:

Anonymous said...

Thanks to you and my trusty blackberry.. I will pass a fina thanks for the aar calc...ps go cubs!!!

Haphols said...

NOTE: Average Accounting Return is a horrible way to analyze a project. It doesn't take into consideration time-value of money. Unlike other measures, it gives you a relative number, but not as definitive as NPV. You should not use this calculation in the real-world

Anonymous said...

Thank you!

Anonymous said...

Thank you, just one question why do you divide 12m$ with 2 ?

thank you!

Anonymous said...

OK, I guess this isn't monitored any more, but 'll try....

October 7, 2012's question is excellent.

There are two ways to look at this that challenge Dr T's assumption that the average asset value is $6million:

1. Given that you've taken income numbers from period ends and because write downs occur (normally) at period end, the books would have a series of asset values: $9 million, $6 million, $3 million and then $0 The average of this series of numbers is (9+6+3+0)/4 = $4.5 million.

2. Another way of thinking about it: You divide the numerator in the AAR equation by 4 (as there are four years) but only dividing the denominator by 2. That doesn't work mathematically. If that's the case, then you should just add all the revenue and divide by two as well.

If this was another type of depreciation, would you not use the averaging as I have done above - by taking numbers at discrete periods and averaging by the number of periods?

Can you please explain?

Thanks!

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