Capital Investment Decisions
Accounting Rate of Return
ARR measures average annual accounting profit as a percentage of initial investment.
Concept First
Learn It Step By Step
Start with the business meaning, then move into the formula.
What is Average Annual PAT?
PAT is the profit left after finance cost and tax. It is the profit base available to shareholders, subject to dividend and retention decisions. Example: final profit available to shareholders after all expenses, interest, and tax.
What is Initial Investment?
Project cash-flow inputs must be kept consistent across years before applying the investment decision rule. Example: machinery cost, installation cost, and initial working capital paid today to start a project.
How should I read the answer?
ARR is easy for non-finance managers because it uses accounting profit, but it ignores time value of money and uses profit rather than cash flow.
Formula Lab
Understand the Formula
Read the formula like a business sentence before calculating it.
Formula
ARR = Average Annual PAT / Initial Investment x 100
Solved Case Study
Read the Numbers Like an Analyst
Work through one business case slowly: understand the situation, calculate the ratios, then interpret what the numbers are really saying.
Case context
TechVision PAT over five years totals Rs. 154L, average PAT Rs. 30.8L. ARR = 30.8 / 50 x 100 = 61.6 percent.
1. Find average annual PAT
TechVision's total PAT over five years is Rs. 154L.
2. Compare average PAT with investment
ARR uses accounting profit, not cash flow.
The project earns an accounting return of 61.6% on the initial investment.
3. Interpret carefully
ARR is easy to communicate but ignores time value of money and can differ from cash-flow-based project value.
Interpretation
What This Means In Practice
Read the result as a business signal, not as a standalone number.
Capital decisions are cash-flow decisions
ARR is easy for non-finance managers because it uses accounting profit, but it ignores time value of money and uses profit rather than cash flow. The question is not only whether the project is attractive on paper. Ask when cash goes out, when cash comes back, what risk it carries, and whether returns beat the cost of capital.
Decision lens
Use ARR as an accounting profitability check, not as the sole investment decision tool. Use the method as one part of a decision: strategic fit, NPV, IRR, payback risk, funding capacity, and sensitivity to forecast errors all matter.
Key Takeaway
Use ARR as an accounting profitability check, not as the sole investment decision tool.
Practice Checkpoint
Check Your Understanding
Work through the quiz in smaller sets. Your answers stay visible while this page is open, so you can review before moving on.
Question 1 of 20
Level 1Why is ARR easy to communicate?
Question 2 of 20
Level 1Which is a limitation of ARR?
Question 3 of 20
Level 1ARR is affected by:
Question 4 of 20
Level 1Which underlying item must you understand before calculating or interpreting the result?
Question 5 of 20
Level 1Which statement is the best conceptual reading of this measure?
15 questions remaining in this lesson.
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Capital Investment Decisions
Knowledge Path
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