Finance - Investment
Theory 2 - Average rate of return - how much do you get on average?
The average rate of return, like the payback period method, looks at the expected net cash flows (income - expenses) of the investment project. It then measures the average net return each year as a percentage of the initial cost of the investment. Let's look at an example. A firm is looking at buying a new automatic painting machine. The cost of the machine is 200,000 and the expected net cash flows are:
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Net cash flow | 50,000 | 55,000 | 65,000 | 75,000 | 75,000 |
The total return from the project over the five years is 320,000 (the sum of the five years). If we subtract the original cost of 200,000 from this, we get the net return from the investment to be 120,000. This took 5 years to earn and so the annual return is 120,000 divided by 5 which is 24,000 per annum. To get the average rate of return, we use the following formula:
| Average rate of return = | Net return per annum | x 100 |
| Capital cost |
From the figures above this gives us:
| Average rate of return = | 24,000 | x 100 |
| 200,000 |
= 12%
This suggests that every £1 worth of investment yields an average 12p return each year.
Why not now have a look at the case study and practice using this technique?
