Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital. The average rate of return ("ARR") method of investment appraisal looks at the total accounting return for a project to see if it meets the target return.
An example of an ARR calculation is shown below for a project with an investment of £2 million and a total profit of £1,350,000 over the five years of the project.
The ARR for the project is 13.5% which seems a reasonable return. The project looks like it is worth pursuing, assuming that the projected revenues and costs are realistic.
A key question is - how does this return compare with the target return for investments by this business?
The main advantages and disadvantages of using ARR as a method of investment appraisal are as follows:
Advantages of ARR
ARR provides a percentage return which can be compared with a target return
ARR looks at the whole profitability of the project
Focuses on profitability – a key issue for shareholders
Disadvantages of ARR
Does not take into account cash flows – only profits (they may not be the same thing)
Takes no account of the time value of money
Treats profits arising late in the project in the same way as those which might arise early
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