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Return on average investment

return on investment - a person planting a seedling that has three twenty dollar bills as leavesThe return on average investment is also called the accounting rate of return. While payback period and net present value relates to the future cash flows, the return on average investment relates profit to the average investment. Return on average investment requires depreciation to be deducted from the cash flows from an investment to calculate an annual profit figure.

Return on average investment is calculated in four steps:

  1. Calculate annual investment profit by deducting depreciation from cash inflow.
  2. Calculate average profit by dividing total investment profit by its useful life.
  3. Calculate average investment by adding the initial cost and the residual value opens in a new window and dividing the result by two.
  4. Calculate the return on average investment opens in a new window by dividing average profit by average investment.

The formula for return on average investment is shown below.

return on average investment equals  average profit divide by average investment

The formula to calculate average investment is shown below.

average investment = opening investment + investment at the end of useful life divide by 2

For example, Comfortware is considering the purchase of new machinery. The machinery's purchase price is $36 000 and it is expected to have a useful life of four years with a residual value of $6000. Straight line depreciation opens in a new window will be used. The expected cash flows from using the new machinery are as follows.

Year 1 Year 2 Year 3 Year 4
$10 000 $9 000 $9 000 $8 000


Straight line depreciation will be $7500 per period (cost less residual value divided by useful life).

Calculating the average profit for the four years is as follows.

 

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Return on average investment opens in a new window

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