Project appraisal - part 2

In this lesson

1. 0:00 Accounting rate of return explained
2. 1:14 Calculating the investment denominator
3. 2:10 Decision rule and percentage conversion
4. 3:29 Worked example: Gekko machine investment
5. 5:52 Identifying distracting information
6. 6:31 Strengths and weaknesses of ARR

About this lesson

You'll also understand when ARR is useful and its limitations compared to other appraisal methods like payback period. The accounting rate of return is based on accounting profits rather than cash flows. You calculate it by dividing average annual profit before interest and tax by the investment amount (either initial or average investment). The average investment is found by adding the initial outlay to the scrap value and dividing by two. Once calculated, express the result as a percentage and compare it against your business's target rate: if ARR exceeds the target, accept the project; if it falls short, reject it. This technique appears across Performance Management, Financial Management, and Strategic Business Leader papers. It's straightforward to understand and communicate to stakeholders, and it considers the entire project life unlike payback period. However, ARR has important drawbacks: it ignores the time value of money, treating cash today the same as cash in the future, and it's vulnerable to profit manipulation through different accounting policies. Knowing these strengths and weaknesses will help you choose the right appraisal method and avoid the traps that can appear in exam questions.

Duration: 8m