Accounting Rate of Return

Accounting Rate of Return (ROR) is used by decision makers as part of the capital budgeting process. This method does not include discounted cash flows, which differentiates it from the other capital budgeting methods. ROR places an emphasis on accounting net operating income and estimates the revenues of a potential project or investment, while considering the expenses that will be related to the proposed project. The formula is as follows:

Rate of Return =
Cash Inflows − Depreciation(Note 1) ÷ Initial investment

Note 1. Includes salvage value from the sale of equipment being replaced

Additional Notes:
Depreciation = Cost - Salvage Value ÷ Useful Life

Sample Rate of Return Problem

Big Co. is a soda bottling plant. They are considering a capital investment project that would expand their production line; production capacity. The new production line will increasse revenues by approximately $31,000. The necessary equipment for this improvement will be $163,200 with a life expectancy of the equipment to be 8 years. There is no projected salvage value because this is an expansion.

Rate of Return = $31,000 − 20,400 / $163,200

= $10,600 / $163,200

= 6.4951%