AQA · GCSE · Business
Course version: 8132 · Version from Sept 2017
Financial terms and calculations: Average rate of return
Average rate of return (ARR) measures the average annual profit an investment generates as a percentage of its initial cost.
Checked against the AQA 8132 specification (opens in a new tab) on .
- Point 3 of 10
- 4 key terms
Study notes
From the checked teaching notes for this specification point.
The idea
Average rate of return (ARR) measures the average annual profit an investment generates as a percentage of its initial cost. To calculate it, first find total net cash flow over the project's life by summing annual net cash flows (cash inflows minus cash outflows). Then subtract the initial investment to obtain total profit. Divide total profit by the number of years to get average annual profit. Finally, divide average annual profit by initial investment and multiply by 100 to express as a percentage. For example, a machine costing £50,000 yields total net cash flows of £80,000 over 5 years. Total profit is £80,000 − £50,000 = £30,000. Average annual profit is £30,000 ÷ 5 = £6,000. ARR is (£6,000 ÷ £50,000) × 100 = 12%. A higher ARR indicates a more favourable return relative to cost, but ARR ignores the timing of cash flows and the time value of money.
What earns the marks
- Calculate total net cash flow by summing all annual net cash flows over the project's life.
- Deduct the initial investment from total net cash flow to find total profit.
- Divide total profit by the number of years to obtain average annual profit.
- Divide average annual profit by initial investment and multiply by 100 to express ARR as a percentage.
- Interpret a higher ARR as a more favourable return relative to the initial cost, and recognise that ARR ignores the timing of cash flows and the time value of money.
Common mistakes and how to put them right
Forgetting to subtract the initial investment before averaging profit.
Put it right: Total profit = total net cash flow − initial investment.
Dividing by the wrong number of years, such as using the project life plus one.
Put it right: Use the exact number of years over which the net cash flows occur.
Expressing ARR as a decimal rather than a percentage.
Put it right: Multiply the ratio by 100 and include the % symbol.
Exam tips
- Show each step of your calculation clearly so that method marks can be awarded even if the final answer is wrong.
- Check that all cash flows are net (inflows minus outflows) before summing them.
- State the formula you are using before substituting numbers, and round only at the final stage unless told otherwise.
Try the lesson
The start of the Financial terms and calculations: Average rate of return lesson, made from checked teaching notes for this specification point.
Have a go first
A business is comparing two investment projects. Project A costs £50,000 and is expected to generate a total net profit of £60,000 over 4 years. Project B costs £80,000 and is expected to generate a total net profit of £80,000 over 5 years. Which project has the higher average rate of return, and by how much?
Listen
Average rate of return (ARR) measures the average annual profit an investment generates as a percentage of its initial cost. To calculate it, first find total net cash flow over the project's life by summing annual net cash flows (cash inflows minus cash outflows). Then subtract the initial investment to obtain total profit. Divide total profit by the number of years to get average annual profit. Finally, divide average annual profit by initial investment and multiply by 100 to express as a percentage. For example, a machine costing £50,000 yields total net cash flows of £80,000 over 5 years. Total profit is £80,000 − £50,000 = £30,000. Average annual profit is £30,000 ÷ 5 = £6,000. ARR is (£6,000 ÷ £50,000) × 100 = 12%. A higher ARR indicates a more favourable return relative to cost, but ARR ignores the timing of cash flows and the time value of money. A strong answer earns marks for these points. Calculate total net cash flow by summing all annual net cash flows over the project's life. Deduct the initial investment from total net cash flow to find total profit. Divide total profit by the number of years to obtain average annual profit. Divide average annual profit by initial investment and multiply by 100 to express ARR as a percentage. A common slip: Forgetting to subtract the initial investment before averaging profit. Instead, total profit = total net cash flow − initial investment. Exam tip: Show each step of your calculation clearly so that method marks can be awarded even if the final answer is wrong.
Key words
Say what each word means before you turn the card.
Average rate of return
Try answering aloud or in your head before turning the card.
Total net cash flow
Try answering aloud or in your head before turning the card.
Total profit
Try answering aloud or in your head before turning the card.
Average annual profit
Try answering aloud or in your head before turning the card.
See every definition
- Average rate of return
- Measures the average annual profit an investment generates as a percentage of its initial cost.
- Total net cash flow
- Found by summing annual net cash flows, which are cash inflows minus cash outflows, over the project's life.
- Total profit
- Obtained by subtracting the initial investment from total net cash flow.
- Average annual profit
- Calculated by dividing total profit by the number of years.
There is more to this lesson
The full lesson goes on to check your understanding and help you earn the marks. Create a free account to carry on, with your progress saved.
A week of Premium from your first lesson · Then the free plan continues · No card, no charge
Test your understanding of Financial terms and calculations: Average rate of return
Active recall beats re-reading. Take an instant quiz now to test what you’ve learned and lock it into long-term memory.
A week of Premium from your first lesson · Then the free plan continues · No card, no charge