📊 What is Average Rate of Return (ARR)?
Definition: The average rate of return (ARR) measures the average annual profit from an investment as a percentage of the initial cost.
Formula: ARR = (Average annual profit ÷ Initial investment) × 100
Where: Average annual profit = (Total profit over life of investment) ÷ Number of years
Unlike payback, ARR considers the total profitability of the investment over its entire life and expresses it as a percentage — making it easy to compare with other options.
ARR gives you a percentage return you can compare against interest rates at the bank — if ARR is higher, the investment beats saving your money! 🏦
🔢 Calculating ARR Step by Step
Example: A business invests $80,000 in new machinery. Over 4 years, the net cash flows are:
Year 1: $25,000 Year 2: $30,000 Year 3: $35,000 Year 4: $20,000
Step 1: Total net cash flows = $25,000 + $30,000 + $35,000 + $20,000 = $110,000 Step 2: Total profit = $110,000 − $80,000 (initial cost) = $30,000 Step 3: Average annual profit = $30,000 ÷ 4 = $7,500 Step 4: ARR = ($7,500 ÷ $80,000) × 100 = 9.4%
Don't forget to SUBTRACT the initial investment to get profit! Total cash flows − initial cost = total profit. This is a common student mistake 🚫
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⚖️ Advantages & Disadvantages
Advantages
- Considers the total profitability over the full life of the investment
- Gives a percentage — easy to compare with interest rates and other investments
- Useful for comparing projects of different sizes and durations
- Focuses on PROFIT, not just cash flow
Disadvantages
- Ignores the timing of cash flows — doesn't matter if profit comes early or late
- Ignores the time value of money (like payback)
- Uses averages — can hide big differences between years
- Doesn't show how quickly the investment is paid back
🎯 Using ARR to Make Decisions
When using ARR to choose between investments:
- Higher ARR is better — it means a higher percentage return
- Compare ARR to the interest rate on savings — investment should beat it
- Compare ARR to a target/criterion rate set by the business
- If ARR is negative — the investment loses money overall — reject it!
Example: Project A has an ARR of 15%. Project B has an ARR of 9%. Bank interest rate is 5%. Both beat the bank rate, but Project A is preferred as it offers the higher return.