Rate of Return
Business: Edexcel GCSE, topic 2.4.4
Average Rate of Return
Average rate of return (ARR) is a way of measuring how good an investment project is for a business.
Average rate of return
- It is calculated by working out the average profit the firm makes from the project per year as a percentage of the initial investment.
- The higher the ARR is, the better a project is for a business. This is because they are making a higher proportion of their investment back each year.
Average rate of return
- If a firm invests £100,000 in new machinery which lowers its costs by £20,000 per year for 10 years.
- Total net profit (for all 10 years) = 20,000 x 10 – 100,000 = £100,000.
- Project length = 10 years.
- Average profit made each year = 100,000/10 = 10,000.
- Then simply divide this by initial investment to calculate it as a %.
- ARR (%) = 10,000/100,000 x 100 = 10%.
Test yourself on Rate of Return
If a firm buys a new tractor for £200,000 and it reduces costs by £20,000 each year for 10 years, what is the Average Rate of Return on the project?
What is average rate of return?
Why do businesses want a high average rate of return on their investments?