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Average Rate of Return A2 Business Studies

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Aims and Objectives Aim: To understand the investment appraisal technique: Average Rate of Return. Objectives: Define ARR Calculate ARR Analyse ARR results Evaluate ARR method

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Starter Explain what the payback method calculates. Explain two benefits of the payback method. Explain two drawbacks of payback method.

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ARR Definition Average Rate of Return assesses the merits of an investment by calculating the average annual profit as a percentage of the initial investment.

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Step 1 Calculate the average annual profit by adding up all net cash flows divided by the number of years. Average annual profit = Total net cash flow / Number of Years

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Step 1 Machine A = (750,000) + 142,500 + 192,500 + 252,500 + 252,500 + 292,500 = 382,500 Average Annual Profit = 382,500/5 = 76,500

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Step 2 Divide the average annual profit by the initial investment and show as percentage. ARR = (Average Annual Profit/Initial Investment) x 100

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Step 2 ARR = (76,500/750,000) x 100 = 10.2% The ARR for machine A is 10.2 %

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Machine B Calculate the ARR for machine B. Show all calculations and formulas in your working out. Make everything obvious to the examiner!

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Analysis and Evaluation of ARR Higher the ARR the more potentially profitable the investment. Analyse machine As and machine Bs ARR.

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Evaluation: Benefits & Drawbacks Discuss the benefits and drawbacks of ARR method. Consider: Interest Rates and lending ROCE Cash Inflows Comparisons

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Evaluation: Benefits Easy comparison with other forms of investment Can compare with interest rate Compared to current or target ROCE figure

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Evaluation: Drawbacks Does not take into account specific timings of cash inflows. An investment may appear profitable, but if it takes four years before a positive net cash flow is achieved this might threaten the firms short term survival

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Plenary Define ARR Explain how to calculate ARR.