Average Rate of Return (ARR) (DP IB Business Management)

Average Rate of Return (ARR)

• The Average Rate of Return compares the average  profit per year generated by an investment with the value of the initial capital cost 

• The average rate of return is calculated using the formula and is expressed as a percentage

  • This makes it easy to compare different investment options

Evaluation of Average Rate of Return (ARR)

Limitations of using Investment Appraisal

• Each of the investment appraisal techniques relies upon forecasted future cash flows which may lack accuracy

  • Managers compiling cash flow forecasts may lack experience or may be biased towards a particular investment

  • Incomplete past data may make forecasting imprecise or mean that confidence in the data used to compile the forecast is limited 

• Longer-term forecasts used to predict returns on investments are particularly prone to inaccuracy for a variety of reasons

  • Unexpected increases in costs

  • The arrival of new competitors

  • Changes in consumer tastes

  • Uncertainties arising as a result of economic growth or recession

• Factors other than the cost of investment and the return on investment are not considered

  • Business finances and availability of external finance to fund the investment

  • The overall corporate objectives 

  • Potential for positive public relations or meeting social responsibilities