Introduction
It is always pertinent to understand the expected average returns from the investment you are going to make. It helps you analyze the risk and opportunities involved in the investment, and whether the risk justifies the returns you will get. In order to do so, investors calculate the Average rate of Return, also called the Accounting Rate of Return, to analyze if the investment is worth it or not.
This guide will help you understand the average rate of Return and how you can calculate it with the help of relevant examples.
What does the Average rate of Return mean?
The average rate of Return means the average amount of return an investor expects on his initial investment at the end of the investment period. It is calculated by first determining the average annual returns on the investment after deducting taxes and dividing it by the initial investment.
The expected returns can be annual, monthly, or quarterly, depending upon the nature of the investment. The value is then represented in percentage terms.
Now let’s check out how to calculate the average rate of Return along with the help of the formula.
Formula
The average rate of Return is mathematically represented as-.
Average rate of return= Average Annual net Returns after taxes / Initial Investment * 100
To find the average annual returns, you will have to apply the below formula:
Average Annual Return= Sum of all the Annual Returns / No. of years investment is expected to last
Calculation
Now let’s check out the following step-by-step process to calculate the average rate of Return.
- First, find out the annual earnings, i.e., profits earned from the investment. You can do so by subtracting the investment cost, including depreciation (in case of fixed investments) from the total earnings received from that investment. So if the investment is made for 5 years, then find out the annual earnings for each year.
- Now you need to find out the annual average returns from the investment. To do so, add the annual profits for all the years and divide it by the number of years the investment is made.
- For one time investment, find the initial investment, and for regular investment, calculate the average investment over the period of time.
- Lastly, divide the annual average returns by the initial investment and multiply it by 100% in the case of a one-time investment. For regular investment, divide the annual average returns by the average investment and multiply it by 100% to find out the average rate of Return.
Example
Now let’s understand the concept further by taking an example of an Indian Corporate house Tata Power. They have made a fixed investment on Power projects for 3 years. The investment is expected to give returns of 50 Lakhs in the first year, 60 lakhs in the second year, and 70 Lakhs in the third year (all monetary value in rupees).
The initial investment made by Tata Power is 5 crores, and the investment life is 3 years.
With this, the first step to calculating the average rate of returns is finding out the average annual returns.
Annual Average returns= Sum of Profits of Year 1, Year 2 and Year 3/ Investment period
= 50L + 60L + 70L / 3 (years)
= 60 Lakhs
Now for calculating the average rate of Return for Tata Power, follow the formula below.
Average Rate of Return = Annual Average Returns / Initial Investment
= 60L / 5 crores * 100%
= 12%
Therefore the average rate of Return of the investment made by Tata Power is 12%.
Limitations
The concept also has its flaws and limitations, which investors should keep in mind before making any investment decision based on the average rate of Return. Following are the limitations of the concept:
- One of the primary limitations of the average rate of Return is that it doesn’t take into account the time value of money. It simply means that inflation decreases the purchasing power of money in later years. Therefore, the profits you get in the future will have less value than the profits received today. Simply saying, the average rate of Return does not consider inflation. This can have a severe effect on your investment.
- The average rate of Return only includes the accounting information and is not based on the actual cash flow.
- Moreover, the average rate of Return also has consistency issues as different financial analysts can calculate it in different ways.
- Lastly, if two investments give the same returns, investors cannot differentiate both on the basis of the amount of money required.
Conclusion
With all its flaws and limitations, the average rate of Return is still a simple and quick way to check out the cost-benefit analysis of any investment in the initial planning period. The investors also use this metric to rank the assets, decide the investment plan per the ranking and include them in the portfolio.
Moreover, the data used for calculating the same can be easily interpreted and accessed. Although it does not factor in the time value of the investment, it provides a brief outlook of the worthiness of the investment.
References
- https://www.educba.com/average-rate-of-return-formula/
- https://www.accountingtools.com/articles/average-rate-of- return#:~:text= The%20average%20rate%20of%20return%20is%20the%20 average%20annual%20amount, investment%20is%20expected%20to%20last https://www.wallstre
- https://www.wallstreetmojo.com/average-rate-of-return-formula/
- https://www.investopedia.com/terms/a/averagereturn.asp
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