AAR in finance commonly refers to Average Accounting Return. It’s a simple, yet often criticized, method of evaluating the profitability of a potential investment or project. It provides a quick, back-of-the-envelope calculation to understand whether an investment generates sufficient returns based on accounting profits.
The formula for calculating AAR is straightforward:
AAR = (Average Net Income / Average Book Value of Investment) * 100
Let’s break down the components:
- Average Net Income: This is calculated by summing the net income generated by the investment over its lifespan and dividing it by the number of years. Net income is the company’s profit after all expenses, including taxes, are deducted.
- Average Book Value of Investment: This is the average carrying value of the asset over its lifetime. Often, this is calculated as (Initial Investment + Salvage Value) / 2. Depreciation reduces the book value over time, reflecting the asset’s declining usefulness.
The resulting AAR is expressed as a percentage. This percentage is then compared to a predetermined hurdle rate, which represents the minimum acceptable rate of return for the company. If the AAR exceeds the hurdle rate, the project is generally considered acceptable from an AAR perspective. Conversely, if the AAR falls below the hurdle rate, the project is likely to be rejected.
Advantages of using AAR:
- Simplicity: The calculation is easy to understand and implement, making it accessible to individuals with limited financial expertise.
- Readily Available Data: AAR relies on accounting data, which is readily available in financial statements.
- Initial Screening Tool: It can serve as a quick and easy initial screening tool to filter out obviously unattractive projects before conducting more complex analyses.
Disadvantages of using AAR:
- Ignores Time Value of Money: This is the most significant drawback. AAR doesn’t account for the fact that money received today is worth more than the same amount received in the future. It treats all income equally, regardless of when it’s earned.
- Based on Accounting Data: AAR relies on accounting profits, which can be manipulated through accounting policies. Accounting profits may not accurately reflect the true cash flows generated by the project.
- Arbitrary Hurdle Rate: The hurdle rate is often subjective and based on managerial judgment. This can lead to inconsistent decision-making.
- Doesn’t Consider Risk: AAR doesn’t explicitly incorporate the risk associated with the investment. Riskier projects should ideally require higher returns.
In conclusion, while AAR is easy to calculate and understand, its significant limitations, particularly ignoring the time value of money, make it a less reliable investment appraisal technique compared to methods like Net Present Value (NPV) or Internal Rate of Return (IRR). AAR is best used as a supplemental tool for initial screening, and its results should be interpreted with caution. More sophisticated techniques are generally preferred for making critical investment decisions.
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