The average rate of return – The average annual amount that reflects the expected rate or percentage of return on an investment or asset, compared to the initial costs or expenses established, is based on information inferred from financial reports and statements. Therefore, the value of the expected average return is calculated by dividing the average return on the asset by the initial investment costs and expenses to derive the ratio expected to be achieved over the useful or expected life of the asset.
The average rate of return is an important measure or criterion in the capital balance, and it is useful for the company to calculate the rate of profitability of its investments. The company also uses this measure to compare its multiple projects and determine the expected rate of return from each project to choose the most appropriate one. This metric looks at potential annual expenses, including a factor or component of depreciation that is closely related to the project.
Arithmetic equation used to calculate the average rate of return
Average Annual Profit / Initial Investment = Average Rate of Return
Steps for calculating the average rate of return
The company first calculates its annual net profit from the project or investment, which includes returns minus any annual expenses or costs incurred in implementing the project or investment. If the investment is a fixed asset such as property, plant, and equipment (PP&E, the company subtracts any expenses incurred on the depreciation factor from the annual returns with the aim of eliciting the annual net profit.
Then the company divides its annual net profit by the initial costs or expenses of the asset, and the result of the arithmetic equation appears in the form of a decimal value. The result is then multiplied by 100 to derive it as a percentage. If we assume that a company wants to invest in a project with an initial cost of $250,000 and the project is expected to generate revenues over the next five years, amounting to $70,000 for one year, then the company calculates the average rate of return by dividing the expected return ($70,000) by the value of its initial investment ( $250,000), so that the inferred result is in the form of a decimal number, and therefore the result is multiplied by 100 to derive the average rate of return equal to 28%.
Advantages of calculating the average rate of return
- The steps of the arithmetic equation are easy to follow and understand.
- This criterion measures the profitability of the entire project over its useful life.
- The formula used depends on the accounting information available in the company, which is easy to understand by all people, regardless of their educational levels and job titles.
Disadvantages of calculating the average rate of return
- The average rate of return does not consider the time value of money or cash flows, which are important to ensure the continuity of the operating business of the company.
- It is difficult to distinguish between projects and compare them based on the amount of money required to implement the investment, especially if the rate of return for each project or company is equal to the rate of return for another project.
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