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5th Sem Financial Management Notes

Average Rate of Return

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Last updated: 17 July 2023

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.

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Syllabus BHM307

01 Financial Management

  1. MEANING & SCOPE
    1. Meaning of business finance
    2. Meaning of financial management
    3. Objectives of financial management

02 Financial Statement

  1. ANALYSIS AND INTERPRETATION
    1. Meaning and types of financial statements
    2. Techniques of financial analysis
    3. Limitations of financial analysis
    4. Practical problems

03 Ratio Analysis

  1. Meaning of ratio
  2. Classification of ratios
  3. Profitability ratios
  4. Turnover ratios
  5. Financial ratios
  6. Du Pont Control Chart
  7. Practical Problems

04 Funds Flow Analysis

  1. Meaning of funds flow statement
  2. Uses of funds flow statement
  3. Preparation of funds flow statement
  4. Treatment of provision for taxation and proposed dividends (as non-current liabilities)
  5. Practical problems

05 Cash Flow Analysis

  1. Meaning of cash flow statement
  2. Preparation of cash flow statement
  3. Difference between cash flow and funds flow analysis
  4. Practical problems

06 Financial Planning

  1. MEANING & SCOPE
    1. Meaning of Financial Planning
    2. Meaning of Financial Plan
    3. Capitalisation
    4. Practical problems

07 Capital Expenditure

  1. Meaning of Capital Structure
  2. Factors determining capital structure
  3. Point of indifference
  4. Practical problems

08 Working Capital Management

  1. Concept of working capital
  2. Factors determining working capital needs
  3. Over trading and under trading

09 Basics of Capital Budgeting

  1. Importance of Capital Budgeting
  2. Capital Budgeting appraising methods
  3. Payback period
  4. Average rate of return
  5. Net Present Value
  6. Profitability index
  7. Internal rate of return
  8. Practical problems