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C o s t B e n e f i t A n a l y s i s t o o l k i t ( v 2 )
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3.2 Average Rate of Return:
The average rate of return expresses the profits arising from a project as a percentage of the initial
capital cost. However the definition of profits and capital cost vary. For instance, the profits may be
taken to include depreciation, or they may not. One of the most common approaches is as follows:
ARR = (Average annual revenue / Initial capital costs) * 100
For example, a new system will cost £240,000 and is expected to generate total savings of £45,000
over the project's five year life.
ARR = (£45,000 / 5) / 240,000 * 100
= 3.75%
Arguments in favour of ARR
• As with the Payback method, the main advantage with ARR is its simplicity.
• There is also a link with some accounting measures that are commonly used. ARR is similar
to the Return on Capital.
• The ARR is expressed in percentage terms and this, again, may make it easier for managers
to use.
Arguments against ARR
• ARR doesn't take account of the project duration or the timing of cash flows over the course
of the project.
• The concept of savings (or profit) can be very subjective, varying with specific accounting
practice and the capitalisation of project costs. As a result, the ARR calculation for identical
projects could result in different outcomes from business to business.
• Thirdly, there is no definitive signal given by the ARR to help managers decide whether or
not to invest. This lack of a guide for decision making means that investment decisions
remain subjective.
3.3 Net Present Value:
The Net Present Value (NPV) is a Discounted Cash Flow (DCF) technique. It relies on the concept of
opportunity cost to place a value on cash inflows arising from capital investment.
Opportunity cost is the calculation of what is sacrificed or foregone as a result of a particular
decision. It is also referred to as the 'real' cost of taking some action.
Present value is the cash equivalent now of a sum receivable at a later date. If we didn’t spend that
money and banked it instead, the opportunity cost includes both the initial sum and the interest
earned.
NPV is a technique where cash inflows expected in future years are discounted back to their present
value. This is calculated by using a discount rate equivalent to the interest that would have been
received on the sums, had the inflows been saved.
Net Present Value Tables
Net Present Value tables provide a value for a range of years and discount rates:
0
1
2
3
-
-
-
n
Now
1 year
from now
2 years
from now
3 years
from now
n years
from now
