What does the average rate of return measure?

It measures the average annual profit generated by a project, expressed as a percentage of the money invested in it.

How is the average annual profit of a project calculated?

Subtract the initial investment from the total net cash inflows over the project's life, then divide the result by the number of years.

An investment of £50,000 produces net cash inflows of £18,000 a year for 4 years. Calculate the average rate of return.

Total inflows are £72,000, giving a profit of £22,000 and an average annual profit of £5,500, so the ARR is £5,500 ÷ £50,000 × 100 = 11%.

A project costs £60,000 and returns £20,000, £25,000, £30,000 and £25,000 over four years. Calculate the ARR to one decimal place.

Total inflows are £100,000, giving a profit of £40,000 and an average annual profit of £10,000, so the ARR is £10,000 ÷ £60,000 × 100 = 16.7%.

OCR A-Level Business (H436) H436

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Strategy, Risk and Managing Change

Average rate of return

2 things to know
Component 03

Overview

Recall questions on the average rate of return and its formula, calculating average annual profit and ARR, comparing ARR with a criterion rate or interest on deposit, and its advantages and weaknesses compared with payback.

What you need to know

Answer each one before you reveal it.

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Numbers

State the formula for the average rate of return.

Numbers

A machine costs £200,000 and returns total net cash inflows of £300,000 over 5 years. Calculate the average rate of return.

Questions from this subtopic

Each one with the model answer underneath.

1
What does the average rate of return measure?
Model answer
It measures the average annual profit generated by a project, expressed as a percentage of the money invested in it.
2
State the formula for the average rate of return.
Model answer
The average rate of return equals the average annual profit divided by the initial investment, multiplied by 100.
3
How is the average annual profit of a project calculated?
Model answer
Subtract the initial investment from the total net cash inflows over the project's life, then divide the result by the number of years.
4
A machine costs £200,000 and returns total net cash inflows of £300,000 over 5 years. Calculate the average rate of return.
Model answer
Total profit is £100,000, so average annual profit is £20,000 and the ARR is £20,000 ÷ £200,000 × 100 = 10%.
5
An investment of £50,000 produces net cash inflows of £18,000 a year for 4 years. Calculate the average rate of return.
Model answer
Total inflows are £72,000, giving a profit of £22,000 and an average annual profit of £5,500, so the ARR is £5,500 ÷ £50,000 × 100 = 11%.
6
A project costs £60,000 and returns £20,000, £25,000, £30,000 and £25,000 over four years. Calculate the ARR to one decimal place.
Model answer
Total inflows are £100,000, giving a profit of £40,000 and an average annual profit of £10,000, so the ARR is £10,000 ÷ £60,000 × 100 = 16.7%.

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