Average Rate of Return (ARR)

• What does ARR stand for in investment terms?

  Average Rate of Return
• Why is it useful to use real numbers when explaining ARR?

  It provides clarity and continuity in examples
• What are the key components of ARR calculation?

  • Total return from the project
  • Number of years the project lasts
  • Initial cost of the investment
• What is the cost of project 1?

  100
• What are the net inflows for project 1 in year 1?

  40
• What are the net inflows for project 1 in year 4?

  10
• What are the net inflows for project 2 in year 4?

  80
• How do you calculate the total return for a project?

  Add all net inflows over the project duration
• What is the total return for project 1?

  40
• How do you find the average annual return (ARR)?

  Divide total return by the number of years
• What is the ARR for project 1?

  10%
• What is the total return for project 2?

  60
• What is the ARR for project 2?

  15%
• Which project has a higher ARR?

  Project 2
• What are the pros of using ARR?

  • Considers total returns of the project
  • Easy to compare different projects
  • Focuses on profitability for shareholders
• What are the cons of using ARR?

  • Does not adjust for time value of money
  • Ignores timing of cash flows
  • Lacks liquidity focus compared to payback
• How does ARR differ from NPV regarding cash flows?

  ARR does not discount future cash flows
• Why might managers prefer project 1 despite its lower ARR?

  It has a quicker payback period