The Average Rate of Return (ARR) is helpful in business decision-making. It helps companies identify which investments provide higher average returns. ARR ensures that businesses only commit to projects that meet or exceed their expected return, aligning financial decisions with long-term goals.
For instance, a retail company considering investing $400,000 in new store technology is expected to increase annual profits by $80,000 over five years. The ARR, calculated at 20%, is compared to the company's required rate of return. If the required return is 15%, the investment is considered favorable. However, the project would likely be rejected if the required rate is 22%, as it doesn't meet profitability expectations.
Despite its simplicity, ARR has limitations. It does not consider the time value of money, which can lead to an incomplete assessment of an investment's true profitability. Additionally, ARR ignores cash flow timing, treats all profits equally regardless of when they occur, and fails to consider the risks associated with the investment. These limitations make ARR a helpful but incomplete tool, best used alongside other financial metrics like NPV or IRR for a more comprehensive evaluation.
From Chapter 7:
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