7.17 : Decision-making Through Average Rate of Return

The average rate of return or ARR facilitates business decision-making by showing which investments give higher average returns.

ARR ensures that the company only invests in projects that yield a return equal to or above the required return, keeping financial decisions aligned with strategic goals.

Consider the example of Lifecare Hospital's investment decision.

The purchase of medical equipment worth five hundred thousand dollars is expected to increase annual profits by one hundred thousand dollars over five years.

Using the formula, the ARR is calculated to be twenty percent.

The ARR of twenty percent is compared against the company's predetermined required rate of return, which acts as a benchmark for acceptable investments.

If the company's required rate of return is, for instance, fifteen percent, the equipment purchase exceeds the required rate, indicating a favorable investment opportunity.

In contrast, if the required rate of return is, for instance, twenty-three percent, the investment would not meet the company's profitability criteria, likely leading to its rejection.

This evaluation process ensures that every investment contributes positively towards achieving the hospital's long-term financial goals.