Scribd
Upload
275 views

Calculating Average Rate of Return (ARR) : Method and Worked Example

The document describes how to calculate the average rate of return (ARR) for investments to compare their profitability. It provides the steps to calculate ARR as: 1) divide the total net profit by the number of years, 2) divide that average annual return by the initial cost, and 3) multiply by 100 to get the ARR percentage. The document includes an example comparing two machines - the Wax Wonder and Candle Wizard - and recommends choosing the Wax Wonder since it has the higher 32.7% ARR compared to the Candle Wizard's 28.9% ARR.

Uploaded by

hjycjycjyc
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
275 views

Calculating Average Rate of Return (ARR) : Method and Worked Example

The document describes how to calculate the average rate of return (ARR) for investments to compare their profitability. It provides the steps to calculate ARR as: 1) divide the total net profit by the number of years, 2) divide that average annual return by the initial cost, and 3) multiply by 100 to get the ARR percentage. The document includes an example comparing two machines - the Wax Wonder and Candle Wizard - and recommends choosing the Wax Wonder since it has the higher 32.7% ARR compared to the Candle Wizard's 28.9% ARR.

Uploaded by

hjycjycjyc
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 4

Calculating Average Rate of Return (ARR)

Method and Worked Example

The ARR method calculates the average annual percentage return an investment provides for a business.
Investment options can be compared using this method, with the investment returning the highest ARR
chosen. For example, if the ARR for Project A was 15% and for Project B was 20%, then Project B would be
chosen because the ARR percentage is higher than Project A.

The technique used for calculating ARR is as follows:


1. Divide the net profit generated by an investment by the number of years the project is expected to
last (this is the average annual return)
2. Divide the average annual return (your answer to 1.) by the initial outlay / cost of investment
3. Multiply your answer by 100 to give the ARR as a percentage.

Suzy Reason owns a business manufacturing fragranced candles. Suzy is looking to expand her business
and to do this she will need to buy some new machinery to help produce more fragranced candles. Suzy has
searched online and found two machines that are suitable to help her achieve increased output. The cost of
buying each machine and the annual estimated net profits are provided in the table below:

Candle Wizard Cost Wax Wonder Cost


£90 000 £110 000
Year 1 net profit £20 000 £10 000
Year 2 net profit £30 000 £20 000
Year 3 net profit £40 000 £40 000
Year 4 net profit £20 000 £60 000
Year 5 net profit £20 000 £50 000
Total net profit £130 000 £180 000

To calculate the ARR for the Candle Wizard and Wax Wonder:

Candle Wizard Wax Wonder


Divide the total net profit by the £130 000 £180 000
number of years
5 years 5 years
Annual average return = £26 000 = £36 000
Divide the average annual return £26 000 £36 000
by the initial outlay / cost of
investment £90 000 £110 000
= 0.289 (3 d.p.) = 0.327 (3 d.p.)
Multiply result by x 100 to give
28.9% (1 d.p.) 32.7% (1 d.p.)
ARR %

Based on the results above, Suzy would be advised to choose the Wax Wonder as this has the highest ARR.
Question 1
Leeroy Michaels manages a small courier business in Wolverhampton. He wants to expand his business
by buying a van and employing another driver, in addition to the two vans and two drivers he already has
working for his business. Due to the high number of miles anticipated to be driven each year, the van will
not be kept for a long time. Leeroy has provided the following information about the van he is considering
buying and would like to know the ARR for the van before making a decision to buy it.

Cost of van £22 000

Total net profit for the life of the van £56 000

Estimated life 3 years

Calculate the ARR as a percentage to 1 d.p.

Question 2
Mustafa owns a business that transports breakfast to offices across much of South West Cornwall. The
business is growing and wants to invest more money in either buying another delivery van or upgrading
the storage space for food at the current facilities. Mustafa has a budget of £40 000 and can only choose one
option. The following information is available for each of the options:

Net profit New delivery van Upgrade to storage space


Year 1 £12 000 £13 000
Year 2 £13 500 £13 000
Year 3 £16 000 £13 000
Year 4 £16 500 £14 000
Year 5 £16 750 £14 500

Cost £25 000 £35 000

a) Calculate the ARR for each option as a percentage and give your answers to 1 d.p.

b) Which of the two options should be chosen based on the ARR calculation?
Question 3
Ghosia owns a dry cleaning and clothing repair business, which she is looking to expand after two years
of making a profit. As part of her expansion plans, Ghosia is planning to spend money on a new industrial
sewing machine. Ghosia has narrowed her choices to two options. She can only afford to spend money on
one of the options.

a) Use the information in the table below to calculate the ARR for each of the options. Give your answers
as a percentage and to 1 d.p.

Fabric Fastener Super Sewer


Cost £35 000 £40 000
Total net profit £77 000 £84 500
Life of machine 3 years 5 years

b) Which of the two options should be chosen based on the ARR calculation?
Answers
Question 1
84.8%

Question 2
a)
New delivery van: 59.8%,
Upgrade to storage space: 38.6%

b) New delivery van because it has the highest ARR

Question 3
a)
Fabric Fastener: 73.3%
Super Sewer: 42.3%

b) the Fabric Fastener because it has the highest ARR

You might also like