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All 25 Flashcards — Average rate of return
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Question
Two advantages of ARR?
Answer
Considers total profitability over full life; percentage makes comparison easy (vs bank rates, other projects).
💡 Hint
Total profit + easy comparison
Question
ARR formula — state it
Answer
ARR = (Average annual profit ÷ Initial investment) × 100
💡 Hint
Avg profit / Cost × 100
Question
Higher or lower ARR preferred?
Answer
Higher — means a higher percentage return on the investment.
💡 Hint
Higher = better
Question
Invest $80k. Y1:$25k, Y2:$30k, Y3:$35k, Y4:$20k. Calculate ARR.
Answer
Total flows=$110k. Total profit=$110k−$80k=$30k. Avg annual=$30k÷4=$7,500. ARR=($7,500÷$80k)×100=9.4%
💡 Hint
Don't forget to subtract cost!
Question
What is the ARR formula?
Answer
ARR = (Average annual profit ÷ Initial investment) × 100. Average annual profit = Total profit ÷ Number of years.
💡 Hint
Avg profit / Investment × 100
Question
Most common ARR student mistake?
Answer
Forgetting to subtract the initial investment. Total cash flows ≠ total profit!
💡 Hint
Flows − cost = profit
Question
What does ARR measure?
Answer
The average annual profit from an investment as a percentage of the initial cost.
💡 Hint
Annual return as %
Question
Two disadvantages of ARR?
Answer
Ignores timing of cash flows; ignores time value of money. Uses averages that hide year-to-year differences.
💡 Hint
Timing + time value ignored
Question
What should you compare ARR against?
Answer
Bank interest rate (should beat it) and a target/criterion rate set by the business.
💡 Hint
Bank rate + target rate
Question
Total profit = Total cash flows minus ___
Answer
Initial cost — don't forget to subtract the investment!
💡 Hint
Initial cost
Question
How does ARR differ from payback?
Answer
ARR considers total profitability over the investment's entire life; payback only considers time to recover cost.
💡 Hint
Total profit vs time
Question
If ARR is negative, what should the business do?
Answer
Reject the investment — it loses money overall.
💡 Hint
Reject
Question
Why is ignoring timing a problem for ARR?
Answer
A project where all profit comes in Year 1 is treated the same as one where it comes in Year 5 — timing matters!
💡 Hint
Early cash > late cash
Question
Step 1 of ARR calculation?
Answer
Add up ALL net cash flows over the investment's life to get total inflows.
💡 Hint
Sum all flows
Question
ARR advantage over payback?
Answer
Considers TOTAL profitability, not just time to recover cost.
💡 Hint
Total profit focus
Question
Step 2 of ARR?
Answer
Subtract initial cost from total flows to get TOTAL PROFIT.
💡 Hint
Total flows − cost = profit
Question
ARR shares this limitation with payback:
Answer
Ignores the time value of money — both treat future cash as equal to today's cash.
💡 Hint
Time value ignored
Question
Why express ARR as a percentage?
Answer
Easy to compare with bank interest rates and other investments — if ARR beats the bank, invest!
💡 Hint
Compare with bank rate
Question
ARR uses averages — why is this a limitation?
Answer
Can hide big year-to-year differences — one great year can mask several poor ones.
💡 Hint
Averages smooth reality
Question
Project A: ARR 15%. Project B: ARR 9%. Bank rate 5%. Choose?
Answer
Both beat bank rate. Project A preferred — higher return (15% > 9%).
💡 Hint
Highest ARR wins
Question
Why compare ARR to bank interest rate?
Answer
If ARR is lower than the bank rate, the business would be better off just saving the money.
💡 Hint
Investment must beat the bank
Question
Quick: Higher ARR = ___ return
Answer
Better — higher percentage return on investment.
💡 Hint
Better
Question
ARR of 12% vs bank rate of 5%. What should the business do?
Answer
Invest — the project returns 12%, beating the 5% bank rate.
💡 Hint
ARR > bank rate = invest
Question
Steps 3 and 4 of ARR?
Answer
Divide total profit by years = average annual profit. Then (avg ÷ initial cost) × 100 = ARR%.
💡 Hint
Avg profit ÷ cost × 100
Question
ARR focuses on PROFIT; payback focuses on ___
Answer
Cash flow — ARR looks at overall returns, payback looks at when cash comes back.
💡 Hint
Cash flow
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Topic 3.8 hub
Investment appraisal
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