Average Rate of Return
A business has money to invest and two options to choose from. The average rate of return turns each one into a single percentage, so they can be compared. Learn to calculate it, and where it falls short.
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Free interactive practice at using the material, which is what the marks are for.
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Which investment wins?
Imagine a business has 10000 pounds to invest and two options to choose from. Which one is the better bet? The average rate of return turns each option into a single percentage so they can be compared. This module is about calculating the average rate of return and knowing its limits.
Investment appraisal words
Four ideas run through this topic:
What is it for?
What does the average rate of return help a business to do?
- Compare investments and choose the best one
- Pay its staff their wages
- Work out the tax it owes
- Design an advertising campaign
Two steps
The average rate of return is worked out in two steps.
Average the profit
An investment makes a total profit of 6000 pounds over 5 years. Average annual profit = total profit / number of years. What is the average annual profit, in pounds? Enter the number only.
What ARR misses
The average rate of return is useful, but it has limits. It ignores the timing of the returns, so a profit far in the future counts the same as one next year. It ignores the risk of the investment, and it is based on forecast profits that may turn out to be wrong. So use it alongside other information.
Reading the number
Which THREE are limitations of the average rate of return?
- It ignores the timing of the returns
- It ignores the risk of the investment
- It is based on forecasts that may be wrong
- It is always exactly right
- It measures staff morale
Now the ARR
The investment cost 10000 pounds and has an average annual profit of 1200 pounds. ARR = average annual profit / cost x 100. What is the average rate of return, as a percentage? Enter the number only.
Match the meaning
- Average rate of return
- Average annual profit
- Investment appraisal
- A higher ARR
- The average yearly return as a percentage of cost
- Total profit divided by the number of years
- Comparing investments to choose the best
- Usually the more attractive investment
In the right order
Put the steps to calculate the average rate of return in order.
- Add up the total profit over the whole life
- Divide by the number of years for the average annual profit
- Divide the average annual profit by the cost
- Multiply by 100 to get the ARR as a percentage
- Compare the ARR with other investments
Complete the idea
The average rate of _____ compares investments. First find the average annual _____ by dividing the total profit by the number of _____. Then divide by the _____ of the investment and multiply by 100. A _____ ARR is usually the better choice.
True or not?
Tap the TWO statements that are TRUE.
- A higher ARR usually means a more attractive investment.
- ARR ignores the timing of when the returns are received.
- ARR is measured in pounds, not as a percentage.
- ARR takes full account of the risk of the investment.
- A lower ARR is always the better choice.
Make the call
A business must choose between two investments. Use the average rate of return wisely.
- Investment A has an ARR of 12 percent, Investment B has 8 percent. On ARR alone, which looks better?
- Before deciding on A, what limitation should they remember?
- What else should they consider beyond the ARR?
Recommend it
A business is choosing between two investments with different average rates of return. Recommend which to choose.
- Explain how the average rate of return is calculated
- State which investment has the higher ARR and why that matters
- Discuss two limitations of using ARR to decide
- Give a supported recommendation