Evaluate ARR
Assess ARR's simple percentage comparison against its use of profit and average values.
Section 4.4 · Investment appraisal
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. This topic covers future net cash flows, payback, ARR, NPV, IRR and supported investment decisions. Discounted payback and questions involving a residual value at the end of a project are excluded by Cambridge. Practice is self-checked, not an official Cambridge grade. Full timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Use AS Topics 1.5–1.6 for profit, depreciation and financial analysis, and Topic 2.1 for contribution. Keep accounting profit, project cash flow and the time value of money distinct.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
ARR is 22% against a stated target of 18%. What can be concluded?
What you will learn
- Explain ARR's communication strength
- Identify timing and accounting limitations
- Compare with a stated target without overclaiming
A familiar percentage
ARR expresses average accounting profit as a percentage of average investment. Managers can compare it with a target or other projects when they use the same basis.
The result depends on accounting profit, depreciation treatment and the average-investment figure. Different assumptions can change ARR.
ARR does not discount cash flows
ARR averages accounting results and ignores when project cash flows arrive. It may not distinguish early from late receipts.
A project can meet its ARR target but still have a weak cash position or negative NPV. Consider cash-flow methods, risk and non-financial outcomes too.
Pause and explain
Why can ARR and NPV rank projects differently?
Worked example
A business accepts any project with ARR above 15%. A project has ARR 18%, but benefits arrive late and forecasts are uncertain. What does ARR show and miss?
Show the worked solution
- The reported ARR exceeds the stated threshold.
- ARR uses average accounting profit and average investment.
- It does not discount later cash flows or measure forecast uncertainty.
Answer It passes the ARR screen, but management should examine cash timing, NPV, risk and non-financial effects.
Try a topic test
Choose Easy, Normal or Difficult. Save your answers and open worked review after finishing.
Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
Give one strength and two limitations of ARR.
Give me a hint
Consider communication, timing and accounting basis.
Compare my reasoning
- ARR is a percentage that can be compared with a target.
- It is based on accounting profit.
- It ignores cash-flow timing and the time value of money.
ARR is easy to communicate, but uses accounting profit and does not discount cash-flow timing.
Look for these in your work
- Strength stated
- Profit basis noted
- Timing limitation noted
A has ARR 24% and NPV $8,000; B has ARR 20% and NPV $15,000. Which leads under each measure, and why is that not the whole choice?
Give me a hint
State both rankings and their purposes.
Compare my reasoning
- A has the higher ARR by 4 percentage points.
- B has the higher NPV by $7,000 on the supplied basis.
- Check scale, risk and objectives; the methods measure different things.
A leads on ARR and B on NPV. Consider scale, risk and strategic fit.
Look for these in your work
- ARR comparison
- NPV comparison
- Limits stated
A public utility compares different-length projects with ARR targets. What further analysis is useful?
Give me a hint
Keep ARR consistent and test cash-flow timing separately.
Compare my reasoning
- Calculate ARR consistently against the target.
- Use NPV to examine discounted flows across each life.
- Include reliability, safety and service obligations.
Use ARR as one measure, then assess NPV and the utility's safety and service objectives.
Look for these in your work
- Target used
- Timing assessed
- Service considered
Common mistakes
- Claiming ARR accounts for time value
- Treating a target as universal
- Ignoring accounting assumptions
What can you explain now?
Which limitation applies to ARR?
Compare with the explanation
It uses accounting profit and does not discount cash flows
ARR averages profit; NPV and IRR reflect cash-flow timing through discounting.
After trying it yourself, choose your next review. This is your self-assessment.
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Make it stick
Why might ARR and NPV rank projects differently?
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.