What is the average rate of return ?

The Average Rate of Return or ARR is one of three types of investment appraisal that are often asked in the form of a 10 mark question. A question that involves these calculations are often very badly answered across the country and subsequently being able to do them puts you in a very strong position.

Now, the ARR method basically looks at the total accounting return for a project to ultimately see if it meets the target return.

An important component of these questions is to not get put off by the large numerical figures instead go through the questions systematically as often they are very easy.

ARR is an equation which needs to be remembered but don't panic, it is very simple:

ARR (%) - Total net profit / no of years 

               ---------------------------------------- x100

                 Initial cost

In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost £ 1 million to purchase, is expected to last 5 years, and will produce an annual net cash flow of £ 0.5 million.

Net Profit = £500,000 (annual profit) x 5 (no of years) = £2.5 million - 1 million (initial investment)

.... gives us the total net profit of £1.5 million

£1.5million (net profit) / 5 (no of years) = 300,000

300,000 / 1 million ( initial cost) = 0.3

0.3 x 100 = an ARR of 30%

Some of this may seem confusing but believe me once you get to grasp with it, you'll be willing for one of these questions to come up as they will be guaranteed marks.