Investment Appraisal - Average Rate of Return (ARR) - 3.3.2

Investment Appraisal - The use of numerical techniques to predict the financial outcomes of potential capital investments.

Average Rate of Return (ARR) - looks at the total accounting return for a project to see if it meets the target return

Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital.

FORMULA  - AVERAGE RATE OF RETURN

(TOTAL NET CASH FLOW / NUMBER OF YEARS) / INITIAL INVESTMENT X 100 = ARR%

Interpretation of ARR revolves around comparison with other projects and should take into account the level of risk and the period of time over which the return is forecast to take place. If the investment was funded by outside investments they would compare the ARR with potential returns on other investments as well as the potential risks. For example the least risky investment may be to place the money in a bank deposit account, but the ARR on such an investment might only be 2%.

Advantages	Disadvantages
Simple to understand and easy to calculate	Ignores the timing of returns
Focuses on the overall profitability of an investment project	Focuses on profits rather than cash flows
Easy to compare ARR with other key target rates of return to help make a decision.	Does not adjust for the time-value of money
Uses all the returns generated by a project	Projected cash flows are only estimates and so may affect the actual ARR
	Ignores the time needed to actually  gain a benefit from the investment, the opportunity cost aspect