Return on average investment
The 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:
- Calculate annual investment profit by deducting depreciation from cash inflow.
- Calculate average profit by dividing total investment profit by its useful life.
- Calculate average investment by adding the initial cost and the residual value and dividing the result by two.
- Calculate the return on average investment by dividing average profit by average investment.
The formula for return on average investment is shown below.
The formula to calculate average investment is shown below.
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 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.
Year 1 | Year 2 | Year 3 | Year 4 | |
---|---|---|---|---|
Cash flow | $12 000 | $10 000 | $10 000 | $8 000 |
Depreciation | (7 500) | (7 500) | (7 500) | (7 500) |
Profit | 4 500 | 2 500 | 2 500 | 500 |
The return on average investment is 16.7%. The business may have set criteria for proposed capital investments.
For example, if the required rate of return is 20% the investment will be rejected but if the criteria is 15% the project will be approved. Capital investments are ranked according to the rate of return.