Distinguish between the following: Accounting rate of return and Internal rate of return.

Accounting rate of return and Internal rate of return The Accounting rate of return or average rate of return (ARR) method is a non discounted technique of evaluating capital budgeting decision. It is based on accounting information rather than cash flows. For the computation of accounting rate of return the following formula is used: Accounting rate of return = Average annual profits after taxes/ Average capital invested x 100 The Internal rate of return (IRR) is a discounted cash flow technique used to evaluate capital budgeting decision. Unlike ARR method, the IRR method considers time value of money by discounting the cash streams. IRR is the discount rate which equates the aggregate present value of net cash inflows with the aggregate present value of cash outflows of a project. In other word, it is the rate which gives the project Net present value (NPV) of zero. The distinction between the two can be on the following grounds: Cash flows vs. Net profit: IRR takes into account the cash flows whereas the Accounting rate of return takes into account the average net profit over the years. Time value of money: the IRR takes into account the time value of money whereas the ARR does not. Decision making under IRR is a scientific method and a good measure of the rate of return, whereas ARR is not. Denominator: Under IRR, cash flows are matched with original investment whereas under the ARR, average investment is taken into account. Reinvestment Assumption: Under IRR cash inflows are assumed to be reinvested at internal rate of return, whereas no such reinvestment assumption applies in ARR.