Average Rate of Return

The rate of return on an investment that is calculated by taking the total cash inflow over the life of the investment and dividing it by the number of years in the life of the investment. The average rate of return does not guarantee that the cash inflows are the same in a given year; it simply guarantees that the return averages out to the average rate of return.

ARR formula
The formula for ARR is:

ARR = average annual profit / average investment

Where,

Average investment = (book value at year 1+ book value at end of useful life) / 2

Average annual profit = total profit over investment period/number of years.

ARR – Example 1
XYZ Company is looking to invest in some new machinery to replace its current malfunctioning one. The new machine, which costs $420,000, would increase annual revenue by $200,000 and annual expenses by $50,000. The machine is estimated to have a useful life of 12 years and zero salvage value.

Calculate the depreciation expense per year: $420,000 / 12 = $35,000
Calculate the average annual profit: $200,000 – ($50,000 + $35,000) = $115,000
Use the formula: ARR = $115,000 / $420,000 = 27.4%
Therefore, this means that for every dollar invested, the investment will return a profit of about 27 cents.