7.16 : Calculating Average Rate of Return

The average rate of return, or ARR, is particularly applicable in business scenarios when evaluating investment projects or capital expenditures.

This metric, expressed as a percentage, represents the annual return an investment is expected to generate.

Let us examine how ARR is calculated with an example of Lifecare Hospital considering the investment in new medical equipment.

The medical equipment costs five hundred thousand dollars and is expected to increase annual profits by one hundred thousand dollars for five years.

The total profit generated over the equipment's lifespan is calculated by multiplying the annual profit with the equipment's lifespan, resulting in a total profit of five hundred thousand dollars.

The average annual profit is calculated by dividing the total profit by the equipment's lifespan, which amounts to a hundred thousand dollars.

The ARR is then calculated by dividing the average annual profit by the initial investment cost. The result is multiplied by a hundred, yielding an ARR of twenty percent.

This means that the medical equipment is expected to yield an average annual return of twenty percent of its cost over its useful life.