Investment Appraisal: The Case of the New Machinery
Accounting Rate of Return (ARR) in the real world!
Arish Faisal talks us through a real-life scenario as a Finance Manager appraising a decision to purchase machinery.
Accounting Rate of Return (ARR) or Return on Capital Employed (ROCE).
It was a busy morning in the finance department when the CEO walked into your office with an important request.
"We’re considering investing £100,000 in a new machine. Can you tell us if it’s a good decision?"
As the company’s Financial Manager, you know that one of the basic techniques for evaluating investments is the Accounting Rate of Return (ARR), also known as Return on Capital Employed (ROCE). ARR is a simple yet effective method that helps businesses estimate the return they can expect from an investment, based on accounting profits.
You grab your notepad and start crunching the numbers.
The Initial ARR Calculation
The finance team provides you with the projected profits before interest and tax (PBIT) that the machine will generate over the next five years:
To calculate ARR, you first find the average annual profit:
£(20,000+30,000+35,000+28,000+27,000) / 5 = £28,000
Then, using the initial investment (£100,000), ARR is calculated as follows:
ARR=(£28,000/£100,000)×100
ARR=28%
You turn to the CEO and explain:
"Based on our calculations, the investment will generate an average return of 28% per year."
The CEO nods but asks, “How do we decide if this is a good return?”
After checking, you find out that the company’s target ROCE is 25%. Since 28% is higher than 25%, you confidently recommend accepting the investment.
Just as you’re about to finalise your report, the junior accountant interrupts.
"Wait! What about the residual value? The machine won’t be worthless at the end of five years—we can sell it for £20,000!"
Step 2: Adjusting ARR for Residual Value
That’s a great point! Since the company will recover £20,000 at the end of five years, the true investment isn’t £100,000 but something lower. To adjust for this, you calculate the average investment, which considers both the initial investment and the residual value:
Average Investment = (Initial Investment + Residual Value) / 2 Average Investment = £(100,000+20,000)/2
Average Investment = £60,000
Now, the revised ARR is calculated:
ARR = £(28,000/60,000)×100
ARR = 47%
You update the CEO:
"Since we will recover £20,000 from selling the machine, our ARR actually increases to 47% instead of 28%."
This is well above the company’s 25% target, making the investment look even better. The CEO smiles, feeling confident in the decision.
But just as you’re about to move on, the junior accountant raises another concern.
"Wait! The figures we used aren’t actually accounting profits—they’re just cash inflows. We need to account for depreciation!"
Step 3: Adjusting ARR for Accounting Profits
This changes everything. Since ARR is based on profits, not just cash flows, you need to adjust for the loss in value of the machine over time.
You calculate the total depreciable amount:
Depreciable Amount= £(100,000−20,000) = £80,000
The company’s total cash inflows over 5 years remain:
£(20,000+30,000+35,000+28,000+27,000)= £140,000
But actual profits should deduct the total depreciation (£80,000):
Total Profit Over 5 Years=£140,000− £80,000= £60,000
The average annual profit is now: £60,000/5=£12,000
Based on initial investment £12,000/£100,000 x 100% = 12%
Based on average investment £12,000/£60,000 x 100% = 20%
You turn back to the CEO and explain:
“Our actual ARR drops to 12% (if calculated using the initial investment) or 20% (if using the average investment)."
The CEO frowns, thinking for a moment.
"So, the investment isn’t as profitable as we initially thought?"
You nod.
"That’s correct, the return is not meeting our 25% target. “
Final Thoughts: The Strengths and Weaknesses of ARR
As the discussion winds down, the CEO leans forward, tapping a pen thoughtfully against the table.
"So, is ARR the best way to evaluate investments?"
You pause for a moment, knowing this is the perfect opportunity to provide deeper insight.
"ARR is definitely a useful tool, but it has its strengths and weaknesses.”
✅ Why ARR is Great
Simple and Quick – No complex formulas, no discounting, just profits and investment available from the financial statements.
Easy to Understand – Even non-financial managers can grasp it without needing a finance degree.
⚠️ The Limitations of ARR
Profits Are Not Cash – An investment can show good profits on paper, but cash flow is what really matters for shareholders.
Profits Can Be Manipulated – Different depreciation methods can make ARR look better or worse, making comparisons tricky.
Ignores Time Value of Money – £10,000 earned today is worth more than £10,000 earned five years later, but ARR treats all profits equally.
Subjective Decision-Making – ARR is only useful if management sets a reasonable target return. There’s no universal benchmark to decide if an investment is "good" or "bad."
The CEO leans back in their chair, nodding.
"I see now. ARR gives us a quick snapshot, but it doesn’t tell the whole story. Maybe we should also consider other methods, before making a final decision?"
A smile crosses your face.
"Exactly! Investment appraisal isn’t about just one method—it’s about seeing the bigger picture."
The CEO glances around the room, eyes full of new ideas.
"Alright, let’s take this discussion to the board next week. I want to ensure we make the smartest choice for the company."
As you gather your notes, you feel a sense of accomplishment. This is what strategic finance is all about—helping businesses make informed decisions, not just quick ones.
Now, the question remains:
Would you invest in this machine? Or would you explore other investment appraisal methods before making the call? 🤔 Let’s discuss in our next article!
