ARR measures the net return each year as a percentage of the capital cost of the investment.
How do I calculate and present it in the exam?
| Year | Net Cash flow |
| 0 | (50) |
| 1 | 10 |
| 2 | 10 |
| 3 | 15 |
| 4 | 15 |
| 5 | 20 |
| Net profit |
|
| Net profit per annum |
|
| ARR |
|
Again, this is what the examiner expects from you when it comes to presenting ARR, so present it this way.
What do all these numbers mean?
Net cash flow column will be given to you in the case study. It is the cash flow businesses expected over the years. Again, you start with 0 and since the number is negative it represents expenditure (in our case $50000). In the net profit section, all we did was add up all the expected cash influx in each year and then subtract the value of the investment. Then we calculated the net profit per annum — what the profit of the firm will be in those five years after subtracting the value of the investment (in our case $20000/5 years = $4000). Then we calculate the ARR using the formula:
Don’t worry about memorizing this formula – it will be in your formula booklet in the exam.
We got that the ARR is 8%.
If we used this method to appraise different investment projects, we would choose the investment that has the highest average rate of return.
Average Rate of Return (ARR): A Practical Guide for IB Business Management
The Average Rate of Return (ARR) is a financial metric used to measure the profitability of an investment as a percentage of the initial capital cost. It's an essential concept for IB Business Management students to understand and apply in real-world scenarios.
Understanding ARR
ARR calculates the average annual profit of an investment and expresses it as a percentage of the initial investment cost. The formula for ARR is:
ARR = (Average Annual Profit / Initial Investment) * 100%
Calculating ARR for the IB Exam
In the IB exam, you'll be provided with data on investment costs and returns. You'll need to calculate the average annual profit and then use the ARR formula to determine the investment's profitability.
Real-Life Examples
Here are five examples to illustrate how ARR is used in various industries:
Example 1: Manufacturing
A manufacturing company invests $500,000 in new equipment and expects an increase in profits of $100,000 per year for the next 7 years. The ARR would be calculated as follows:
ARR = ($100,000 / $500,000) * 100% = 20%
Example 2: Technology
A tech startup spends $200,000 on development and anticipates a yearly profit of $50,000 over 5 years. The ARR is:
ARR = ($50,000 / $200,000) * 100% = 25%
Example 3: Real Estate
An investor buys a property for $1,000,000 and expects rental income of $120,000 annually for 10 years. The ARR would be:
ARR = ($120,000 / $1,000,000) * 100% = 12%
Example 4: Retail
A retail chain invests $300,000 into a new store and forecasts an average annual profit of $60,000 for the next 8 years. The ARR is:
ARR = ($60,000 / $300,000) * 100% = 20%
Example 5: Agriculture
A farm invests $150,000 in new machinery and expects to increase profits by $30,000 each year for 6 years. The ARR would be:
ARR = ($30,000 / $150,000) * 100% = 20%
Conclusion
ARR is a straightforward way to assess the profitability of an investment. It's crucial for IB Business Management students to understand how to calculate and interpret ARR, as it helps in making informed business decisions.
