Average Rate of Return (ARR)

What is the ARR?

The average rate of return method measures the average net return every year with the cost of the investment.

How is the ARR expressed?

As a percentage- this allows for a straightforward comparison between different investment options.

How is the ARR used when deciding between different investment options?

The investment project with the highest average rate of return is chosen.

What is the formula used to calculate the ARR?

(Average profit per annum / Initial investment cost) x 100

How else can the ARR be used by a business?

In addition to using the ARR to compare capital investment options, ARR can also be used to compare with keeping the money in the bank and comparing against interest rates.

What are the advantages of using the average rate of return method?

• Shows the profitability of the project.

• Includes all the project’s cash flows.

• Allows comparison with costs of borrowing for investment.

• Easy to compare different projects.

What are the disadvantages of using the average rate of return method?

• Ignores the timing of the cash flow.

• Does not allow for effects of inflation on values of future cash flows.