Average Rate of Return (ARR) shows the annual percentage rate of return from the investment.
Why is Average Rate of Return (ARR) of a project important?
Average Rate of Return (ARR) gives the annual Net Cash Flows (or net profits) arising from a project as a percentage of the initial capital cost of the investment. Or, the annual profitability of an investment as a percentage of the amount invested.
Average Rate of Return (ARR) is also often called the Annual Rate of Return.
How to calculate Average Rate of Return (ARR)?
The Initial Cost of Investment which is the original amount invested in the project is also often referred to as the principal. The formula for Average Rate of Return (ARR) is dividing Total Net Cash Flows by Life Expectancy of Investment, and then dividing the Average Annual Net Cash Flow by the Initial Cost of Investment:
| Average Annual Net Cash Flow | |||
| Average Rate of Return (ARR) = | ━━━━━━━━━━━━━━━━━━━━ | x 100 | |
| Initial Cost of Investment |
which is:
| Total Net Cash Flows / Life Expectancy of Investment | |||
| Average Rate of Return (ARR) = | ━━━━━━━━━━━━━━━━━━━━ | x 100 | |
| Initial Cost of Investment |
Where:
Net Cash Flows = Cash Inflows – Cash Outflows
Problems may occur when forecasting the future because no one can predict what and how external forces will affect cash flows. This can make cash flow projections inaccurate. Therefore, managers must take this into consideration.
Examples of calculating Average Rate of Return (ARR)
A. Average Rate of Return of projects with even cash flows.
A business is planning to invest in purchasing a new machine. The new machine will originally cost USD$200,000. This investment is expected to generate on average USD$10,000 in Annual Net Cash Flows. What is the Average Rate of Return (ARR) of this investment project?
| USD$10,000 | |||
| Average Rate of Return (ARR) = | ━━━━━━━━━━ | x 100 | = 5% |
| USD$200,000 |
The Average Rate of Return (ARR) for this investment is 5%.
B. Average Rate of Return (ARR) of projects with uneven cash flows.
A business is planning to invest USD$10,000,000 in purchasing a new fleet of trucks for its transportation center. The new electric trucks will be used for the period of the next four years. They are going to generate the following Net Cash Flows:
In Year 0, the Net Cash Flow is -USD$10,000,000.
In Year 1, the Net Cash Flow is USD$1,000,000.
In Year 2, the Net Cash Flow is USD$1,000,000.
In Year 3, the Net Cash Flow is USD$1,000,000.
In Year 4, the Net Cash Flow is USD$1,000,000.
So, the Total Net Cash Flows of this investment are USD$4,000,000. What is the Average Rate of Return (ARR) of this investment project?
| USD$4,000,000 / 4 | |||
| Average Rate of Return (ARR) = | ━━━━━━━━━━━━━ | x 100 | = 10% |
| USD$10,000,000 |
The Average Rate of Return (ARR) for this investment is 10%.
The four stages in calculating Average Rate of Return (ARR) for projects with uneven cash flows are shown below:
STEP 1: Add up all Net Cash Flows. Net Cash Flows equals to Cash Inflows – Cash Outflows.
STEP 2: Divide Total Net Cash Flows by the lifespan of the project.
STEP 3: Divide this Average Annual Net Cash Flow by Initial Cost of Investment.
C. Average Rate of Return (ARR) of many projects.
A sole trader who is running her own pizza restaurant has large reserves of cash. Instead of simply saving the cash in the bank which pays only 1% interest on a Fixed 1-Year Deposit, she considers using this cash instead to invest in order to become more competitive in the future. She would love to receive more than 1% return from the investment. Currently, there are three opportunities that she can invest in:
- Investment A is to acquire another restaurant. This investment has The Average Rate of Return (ARR) of 11%.
- Investment B is to open the second restaurant like hers in another part of town. This investment has The Average Rate of Return (ARR) of 8%.
- Investment C is to diversify the menu in her current restaurant by offering a larger number of products. This investment has The Average Rate of Return (ARR) of 20%.
Which investment should she choose?
Based on the abovementioned Average Rate of Returns, the sole trader should choose Investment C to diversify the menu in her current restaurant. It is because it has the highest Average Rate of Return (ARR) of 20%. The higher the average percentage of return, the better the investment, under the Average Rate of Return (ARR) method.
Comment on the result of Average Rate of Return (ARR)
Average Rate of Return (ARR) indicates the rate of return that the business can expect to receive from the investment on average each year. If the Average Rate of Return (ARR) is 30%, then the business can expect an annual return of 30% on its investment.
The result of Average Rate of Return (ARR) will be used to assess the risks and rewards involved in making an investment decision. The Average Rate of Return (ARR) will be compared with average annual returns from other investments:
A. Comparing with other projects. The Average Rate of Return (ARR) will be compared with the Average Rates of Return (ARR) on other projects to choose the best one – with the highest Average Rate of Return (ARR). If Project A returns on average 5% per year while Project B returns on average 10% per year, then it will be easy to make the decision between the alternative investments. The firm will choose to invest in Project B.
B. Comparing with criterion rate. The criterion rate is the minimum expected return from an investment that is set by the business before any investment is made. The business may decide to refuse to invest in any project with an Average Rate of Return (ARR) of less than 8% accepting only projects that meet or exceed the Average Rate of Return (ARR) of 8% or higher.
C. Comparing with interest rate on loans. As a basic benchmark, the Average Rate of Return (ARR) can be compared with the base interest rate on bank loans to assess the rewards for the risk involved in making the particular investment. If Average Rate of Return (ARR) is less than the annual interest rate on a bank loan, then, it will not make any sense to borrow money from a bank to invest in the project.
Therefore, the cost of capital should also be taken into account when considering Average Rate of Return (ARR). So, the annual interest rate on loans needs to be considered as the capital cost. If the Average Rate of Return (ARR) is 5% while the interest rate on the money borrowed to fund the project is 8%, it is not worth making that investment.
Average Rate of Return (ARR) – Evaluation
Average Rate of Return (ARR) is a very popular method of evaluating investment projects comparing average annual profit rates. It should be considered together with Payback Period (PBP) which allows for comparisons of project lengths and cash-flow timings.
Advantages of Average Rate of Return (PBP) include:
- Easy to calculate, use and understand. Average Rate of Return (ARR) is one of the simplest and quickest of all the five quantitative methods of Investment Appraisal. The results are quick and easy to calculate, and can be easily understood by managers and other stakeholders.
- Allows to compare projects. Average Rate of Return (ARR) is expressed as a percentage. Managers can compare Average Rate of Return (ARR) of a particular project with other alternative projects. Also, they can put different projects in rank order. The results can be used by the business to ‘screen out’ the best projects, those with the highest Average Rate of Return (ARR). Managers will always be looking for the highest returns from their investments. Average Rate of Return (ARR) can also help to eliminate projects that bring too little returns comparing different investment projects with different costs. Firms will be looking for the investments which give the most returns for the least money invested. It can also be compared with criterion rate as well as compared with interest rate on loans.
- Helps to decide whether to pursue the project. The result of Average Rate of Return (ARR) can be quickly assessed against the predetermined criterion rate of the business. The minimum expected return set by the firm will determine whether to go on with the project or not. In addition, if two projects are predicted to yield the same Average Rate of Return (ARR), then the relatively cheaper project (with lower Initial Cost of Investment) will be more desirable given less financial risk of losing money.
- Useful for firms with profitability problems. Average Rate of Return (ARR) focuses on profitability. Profitability is one of the most important business objectives. It may help businesses that struggle with poor profitability to improve its performance by choosing projects with only very high Average Rate of Return (ARR) to focus on profitability.
- Uses all cash flows. Unlike the Payback Period (PBP) method, the Average Rate of Return (ARR) method uses all of the Cash Flows. All Net Cash Flows, both pre-payback and post-payback are included, in the calculations as Total Net Cash Flows are needed in calculations.
Disadvantages of Average Rate of Return (ARR) include:
- Not comprehensive enough to make final investment decisions. Average Rate of Return (ARR) should only be regarded as one of the first methods to assess competing investments. It could be used as an initial screening tool to include and eliminate certain projects, but it is inappropriate as a basis for making any sophisticated investment decisions. This lack of a definitive guide for decision making means that many investment decisions will remain subjective.
- Focuses on profits only rather than time. This Investment Appraisal method focuses solely on profits and neither on the project duration nor on the timing of cash flows over the course of the project. Therefore, it can encourage a short-term approach to investing – focusing on the short-term benefits while ignoring the potential long-term gains.
- Ignores the timing of the Cash Flows. This could result in two projects having similar or even the same Average Rate of Return (ARR) results, but one could pay back much quicker than the other. Too much concentration on the short-term returns from investment may lead business managers to reject some very attractive long-term projects that yield higher returns after many years just because they have low average rates of return.
- Does not consider time value of money. Average Rate of Return (ARR) does not consider discounting. It does not bring to the present value the future Net Cash Flows. The timing of the Net Cash Flows, hence present value of future money, during the duration of the project is ignored.
- The project’s life span is needed. In order to calculate Average Rate of Return (ARR), Life Expectancy of investment is required. This might be difficult to predict accurately especially when it comes to long-term investment projects in very large and complex Fixed Assets.
- Difficult to accurately predict future Net Cash Flows. Also, Average Rate of Return (ARR) might be easily prone to forecasting errors, especially for longer forecasting periods. Yearly and monthly Net Cash Flows are very, very unlikely to be constant. Monthly revenues, costs and profits will vary as unpredictability is the nature of business environment. For example, demand is prone to seasonal fluctuations, natural disasters happen, prices of raw materials suddenly increase due to military conflicts, etc. Hence, the Average Rate of Return (ARR) might be lower than anticipated.
In summary, remember that Investment Appraisal is evaluating the profitability or desirability of an investment project. There are two ways to do it.
Quantitative Investment Appraisal is using techniques to study the financial issues of investment (think quantity in terms of percentages and money). And, Qualitative Appraisal which is studying non-financial issues that may impact an investment decision (think quality and impact).
