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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