The Average Rate of Return (ARR) is helpful for businesses evaluating potential investments or capital expenditures. This metric, expressed as a percentage, shows the expected annual return on investment compared to its initial cost.

For instance, imagine a manufacturing company investing $300,000 in new machinery. The machinery is projected to generate an additional $60,000 in annual profits over the next five years. The total profit over the lifespan of the investment is $300,000. By dividing this total profit by the five-year lifespan, the average annual profit is $60,000. The ARR is calculated by dividing the average annual profit by the initial investment ($60,000 ÷ $300,000), resulting in an ARR of 20%. This means the investment is expected to generate an average annual return of 20% of its cost.

Although ARR provides a simple way to assess profitability, it does not consider the time value of money or risk, making it less suitable for more detailed financial analysis.

From Chapter 7:

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7.16 : Calculating Average Rate of Return

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7.1 : Introduction to Capital Budgeting

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7.2 : Basics of Investment Decision-making

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7.3 : Importance of Capital Budgeting

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7.4 : Advantages and Limitations of Capital Budgeting

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7.5 : Capital Budgeting Techniques

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7.6 : Payback

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7.7 : Payback Period

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7.8 : Discounted Payback Period

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7.9 : Net Present Value

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7.10 : Net Present Value Method

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7.11 : Decision-making Through Net Present Value

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7.12 : Internal Rate of Return

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7.13 : Calculating Internal Rate of Return

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7.14 : Decision-making Through Internal Rate of Return

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