Average Rate of Return Calculation
This page delves deeper into the average rate of return calculation in investment projects, providing a step-by-step guide and discussing its benefits and drawbacks.
The average rate of return (ARR) is calculated using the formula: (Average net return per annum / Capital outlay) x 100. This method provides a percentage that can be compared against a target set by the business.
Example: If a project has an initial cost of $1,000,000 and generates a total net cash flow of $1,750,000 over 5 years, the ARR would be calculated as follows: ((1,750,000 - 1,000,000) / 5) / 1,000,000 x 100 = 15%
The ARR method has several benefits. It is simple to understand and calculate, focuses on overall profitability, and allows for easy comparison of predictions. However, it also has drawbacks, such as using shallow numbers, disregarding external factors, and ignoring the timing of returns.
Highlight: The ARR method is particularly useful when comparing multiple projects that exceed the target return, as it provides a clear percentage for comparison.
When using the ARR method, it's important to note that the target return set by the business can be subject to manipulation and may not always be reliable. This emphasizes the need for careful consideration and potentially using multiple appraisal methods when making investment decisions.
Quote: "ARR doesn't help when multiple projects exceed target. It makes a decision."
In conclusion, while the average rate of return calculation provides a straightforward way to assess investment projects, it should be used in conjunction with other methods to get a comprehensive view of an investment's potential.
