Average rate of return method

The average rate of return is an accounting method of investment appraisal which determines return on investment by totaling the cash flows over the years for which the money was invested and then dividing that amount by the number of years. The average rate of return does not assure 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.

Let us consider an example. Mr. A spends $800,000 to buy an apartment building. After the deduction of all the operating expenses, real estate taxes, and insurance, he receives $65,000 in the first year, $71,000 in the second year, $69,000 in the third year, and $70,000 in the fourth year. The total net earnings in the four years are $275,000. This total amount is divided by the 4 years being analyzed, to reach $68,750 as an average annual return. This amount of $68,750 is then divided by the initial $800,000 investment to calculate the average rate of return of 8.59 percent. The disadvantage of this procedure is that it does not take into account the time value of money. The initial amount of $65,000 received in the first year was more valuable than the $70,000 received in the fourth year, because the $65,000 could have been invested to earn still more money.

The average investment is defined as the book value of assets tied up. The profit figure used is after depreciation and amortization. ARR is a method which is often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organization. It is rarely used by investors because cash flows are more important to investors and is based on numbers that includes non-cash items. This method does not adjust for the greater risk to longer term forecasts. Finally there are better alternatives which are easier to calculate.

Questions

• What is average rate of return method? Give an example
• Why is this method not used by the investors?