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Special Items

Average rate of return

A financial method of investment appraisal that calculates the (average) net return (profit or savings) of an investment over a period of time and expresses this as a percentage of the initial (capital) cost of the investment. There are several steps involved as follows: (1) Calculate total net cash flow over the life of the project; (2) Calculate the net return over the life of the project: Total net cash flow – capital outlay; (3) Calculate the average annual net return: Net return / number of years; (4) Calculate the ARR%: Average annual net return / initial capital outlay x 100. Example: Capital outlay of a project is £45,000. Project has a 4-year life. Net cash flow (revenue – costs or net savings) end of year 1 is £10,000. Net cash flow end of year 2 is £15,000. Net cash flow end of year 3 is £20,000. Net cash flow end of year 4 is £20,000. If we apply the above figures to the steps for calculating ARR outlined above, then: (1) Total Net Cash Flow over the life of the project = £65,000. (2) Net Return over the life of the project = £20,000. (3) Average Annual Net Return = £5,000. (4) ARR% = 11.11%. The ARR% for the above project is just over 11%. This means that for every £1 invested, the project generates an average of just over 11 pence each year. Whether or not a business should pursue such an investment may depend on whether or not it meets any company policy regarding minimum ARR percentages that must be achieved, the contribution to any specific profit objectives, as well as other financial and non-financial factors. See qualitative factors affecting investment.

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