A level Business Revision – The ARR Method of Investment Appraisal

In this A level Business revision tutorial we introduce the Average Rate of Return (ARR) method of investment appraisal. The ARR is one of three methods of investment appraisal on the new AQA A level Business spec, the new Edexcel Business A level and the OCT Business A level course.

In this investment appraisal video we’re going to try and have a look at a method known as a r r which is of course a pirate’s favorite method of investment appraisal now doesn’t go down very well in my lessons either no reason why should be any better on video with the arr what we’re going to try and do is we’re trying to calculate a percentage and that percentage

Is going to tell us how much of a return this investments going to give us annually if we were to invest in it it’s going to require a couple little sums but if we can remember how to do it and nail it on the exam day it’s going to put it in the top grade boundaries because not all students are going to be able to do this so let’s take a little look here we remember

That one of our criticism of the payback method investment appraisal was they didn’t really factor in the net returns that a project might give us after the year of payback with this little chap on the board who will see that the fourth year is its most lucrative year that’s the year when the net return is the highest force but with payback we didn’t count this six

Million pound t because we’d already paid for ourselves so it didn’t really matter that this project had such a lucrative return in its fourth year well the a our our is a method of investment appraisal but does at least factor in all of the net returns of a project across its entire life and we’re going to try and have a look at how we calculate how the average

Annual profit of this project is expressed as a percentage so that we can see what kind of returns this project is going to provide the organization so this is a project that is going to cost us 10 million pounds and over its four year life we can see that it’s going to make some net returns for us in fact the total net returns if we add these four values together

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Is going to be 17 million pounds so this project is going to return 17 million pounds for the organization but we’ve gone remember we’ve also got to deduct the initial 10 million pounds as well so what we’re really saying is that if we invest in this product is going to make us seven million pounds over a four-year period in fact if we’re over aren’t going to

Be ocd about this let’s get the pound sign on there this chap is going to make us seven million pounds over a four-year cycle now what we’re going to try and do is to try and work out what that kind of return is for us as a percentage the first thing we’re going to do is we’re going to say well if it makes us seven million pounds over four years how much is it

Making us on average every year so if we take our seven million pounds return and divide it by four years we can say year i’ll make a seven million over four years and on average what that means is it’s going to return to us 1.75 million a year we call that the average annual profit that’s its total profit over its entire life but that’s how much on average it’s

Making for us each year of the project now we’re going to go a stage further than that because although we can say alright if we invest in this project is going to want a bridge make us 1.75 million pounds a year we want to try and turn that into a percentage one is that 1.75 million pounds as a percentage of the initial cost of investing in this project and to

Think that it’s a very simple sum again we’ll take our 1.75 million average annual profit there we’ll just divide it by the ten million pound cost of this investment and if we remember to times it by a hundred because whenever we want to work out percentage we’ve always other times it by a hundred and what we can say is that this average annual profit of 1.75

Million is like saying it’s going to make us 17.5% a our our or we can say this 1.75 average annual profit is a 17 point 5 percent return on our initial cost of this project now arr they’re interesting because businesses can compare them to other different measurements to see whether they’ve got a project that might be worth investing in first thing that we can

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Do is perhaps compare ar hours of different investments against each other so if we’ve got two potential projects that we’re considering investing in we’ve got one with our 17.5% arr but we’ve got another project with an arr of 25% if we’re using the ar ar method of investment appraisal to decide what to invest in we wouldn’t go with this project we’d go with the

One with the higher percentage returns we can also perhaps compare our a our rs to other measurements to see whether projects are a good or a wise investment for example imagine we only have this one project that we were considering and it’s got this a our our of 17.5% well that number compares incredibly favorably to the return that we could make just leaving

This 10 million pounds in a high interest bank account and recouping the returns but that would give us even if we put in to near a really generously interested bank account there we might get say a 4% four and a half percent return we can see that investing in a project is far riskier than just leaving the money in a bank account but the reward is a much greater

Return we might get 4% leaving in the bank seventeen and a half percent investing in whatever this project is so the ar r is a really useful way of appraising the viability of an investment so we could compare the arr to current bank interest rates to check whether a scheme is worth the risk that is going to be attached to it if it was only say one percent higher

Than you could get by living in the main care you have to think well is that really worth the risk involved in this scheme whereas with this one because it’s significantly higher this scheme seems like a go or it seems like one that we might want to try and invest it perhaps the criticism we could label at the ar method is first of all it doesn’t prioritize time

Like a payback did for those firms that are cash sensitive that are prone to liquidity problems this one looks at the entire life of a project and assumes that we’re quite happy to wait for year four and that six million pounds rolling in and we can look at the entire duration of a scheme work out how much its annual profit is on average each year firms might not

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Have that luxury of time they might want to prioritize getting that ten million back out of a project as quickly as they possibly can a hour doesn’t account for time the other thing we could say is well look this scheme looks like it’s going to make us six million pounds in the fourth year but hold on a second six million pounds in four years time is not really

Going to be the same value as having six million pounds right now nobody wants to wait four years for 6 million pounds it’s more valuable to have that sum right now for two reasons number one because of inflation 6 million pounds in four years time is not going to buy the firm as much as having 6 million pounds right now would secondly if we had that 6 million

Pounds right now again we could do something with it we could invest it we could make a return on it so waiting for years for 6 million pounds is a little bit of a distortion that’s not a true value because of inflation because if we have that money now we could earn a return on it 6 million pounds in four years times not really as valuable to an organization

As having 6 million pounds right now the arr doesn’t take account of that it doesn’t have any way of discounting the fact that money in the future is not as valuable to businesses as having that money earlier on but that’s why we’ve got our third method of investment appraisal will look at mpv in another video we’ll throw a link to it up there in the corner but

That shows you how you calculate your ar it also tells us how we might kind of interpret the result when we get it hopefully you can do that one in the exam if it comes up it’s one that not all students going to be two managers a good way of differentiating yourself and going for those higher grades if we can good luck as always with your revision we’ll see you

Soon for another investment appraisal video

Transcribed from video
A level Business Revision – The ARR Method of Investment Appraisal By TakingTheBiz