IBBusiness ManagementSLRevision Notes3. Finance & Accounts3.7 Investment Appraisal3.7.2 Average Rate of Return (ARR)

Average Rate of Return (ARR) (SL IB Business Management)

Revision Note

Lisa Eades

Average Rate of Return (ARR)

  • The Average Rate of Return compares the average  profit per year generated by an investment with the value of the initial capital cost
     
  • The average rate of return is calculated using the formula and is expressed as a percentage which makes it easy to compare different investment options
     

fraction numerator open parentheses total space returns space minus space capital space cost close parentheses space divided by space years space of space use over denominator capital space cost end fraction space space space space space space space cross times space space space space space space space space space 100 space space space space space space

Worked example

Creative Frames, a small artwork framing business based in Bermuda, is considering an investment of $40,000 in new machinery. Megan, the business owner, believes that total returns over a 6-year period will be $76,000

Calculate the Average Rate of Return of the proposed investment.   [4 marks]

 

Step 1 - Deduct the capital cost from the total returns

$76,000 - $40,000   =   $36,000    [1 mark]

Step 2 - Divide the outcome by the number of years of use

$36,000 ÷ 6 years      =      $6,000     [1 mark]
 

Step 3 - Substitute the values into the formula

equals space fraction numerator 6 comma 000 over denominator 40 comma 000 end fraction space straight x space 100 equals space 0.15   [1 mark]

  
Step 4 - Multiply the outcome by 100 to find the percentage
    0.15 x 100      =      15%     [1 mark]

 

The Advantages & Disadvantages of Using the Average Rate of Return (ARR)


Advantages


Disadvantages

  • ARR considers all of the net cash flows generated by an investment over time

  • ARR is easy to understand and compare the percentage returns with each other

  • As it depends on an average of cash flows it ignores the timing of those cash flows
     
  • The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time

Limitations of using Investment Appraisal

  • Each of the investment appraisal techniques relies upon forecasted future cash flows which may lack accuracy
    • Managers compiling cash flow forecasts may lack experience or may be biased towards a particular investment
    • Incomplete past data may make forecasting imprecise or mean that confidence in the data used to compile the forecast is limited
       
  • Longer-term forecasts used to predict returns on investments are particularly prone to inaccuracy for a variety of reasons
    • Unexpected increases in costs
    • The arrival of new competitors
    • Changes in consumer tastes
    • Uncertainties arising as a result of economic growth or recession

  • Factors other than the cost of investment and the return on investment are not considered
    • Business finances and availability of external finance to fund the investment
    • The overall corporate objectives 
    • Potential for positive public relations or meeting social responsibilities

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    Lisa Eades

    Author: Lisa Eades

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.