7.15 : Average Rate of Return

The average rate of return, also known as the accounting rate of return, is a financial metric employed in capital budgeting to assess the profitability of potential investments.

The average rate of return, or ARR, provides a straightforward measure of an investment's financial performance. It calculates the annual return as a percentage of the initial investment.

The simplicity and ease of calculation make ARR appealing for quick financial assessments.

Let us consider an example of a Lifecare hospital planning to enhance its services by acquiring new medical equipment.

The cost of this medical equipment is projected at five hundred thousand dollars, which is anticipated to boost annual profits by one hundred thousand dollars for five years.

ARR offers a method for analyzing the profitability of such a purchase. It represents the annual return an investment is expected to generate.

However, the calculation of ARR does not account for the time value of money.

Also, the risk associated with an investment is not considered while calculating the ARR.

Despite these limitations, ARR remains a popular tool for initial investment screening, offering a quick overview of project profitability.