Average Rate of Return (ARR)
3.8 Investment Appraisal
only yield revenue in later years, so investors
DEFINITIONS & FORMULA
must be able to withstand those early years
without positive cash inflow.
Investment Appraisal
The quantitative methods used to calculate
the financial costs and benefits of an
Suppose an investment in real estate that
investment decision.
costs $210,000 is expected to generate the
Average Rate of Return (ARR)
The average profit on an investment project
as a percentage of the amount invested.
ARR =
𝑇𝑜𝑡𝑎𝑙 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 ÷ 𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐿𝑖𝑓𝑒𝑠𝑝𝑎𝑛
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ($)
WORKED EXAMPLE
x 100%
following net cash flows over the next 3
years:
Year 1
$100,000
Year 2
$125,000
Year 3
$110,000
USING THE ARR
Step 1 Total net revenue: $335,000
Strengths
Step 2 Total net profit: $335,000 – $210,000
●
Enables easy comparisons of the
estimated returns (%) of different
investment projects.
●
Easy to calculate, no complex math.
●
Can cover any time frame.
Weaknesses
●
Doesn’t factor in long-term increased
risk and uncertainty associated with
long-term projects.
●
Difficult to accurately estimate a
= $125,000
Step 3 ARR:
Ignores the timing of cash inflows.
●
Affected by depreciation.
Considerations
The ARR would not factor in a lack of cash
flow in earlier years if investments were to
Business Management HL Handout
x 100% ≈ 19.8%
EVALUATION
Comparisons
In order to assess a project’s profitability, the
ARR can be compared to interest rates and
the ARR of other projects. For example:
●
project’s useful lifespan.
●
$125,000 ÷ 3
$210,000
ARR 19.8% > Interest rate 3.54%
Thus, the project is worth the risk.
●
ARR₁ 19.8% < ARR₂ 21.7%
Thus, the project may not be as
profitable as another project.
If the ARR of two projects is the same, then
the cheaper project is more desirable,
because it carries less risk.
S3C5 Ivy Jade Yang