Average gross rate of return
The average gross annual rate of return method is entirely concerned with profitability; the payback period is completely ignored. This method calculates the average proceeds, that is, positive net cash flow, per year over the life of the project and expresses this average as a percentage return per year on the project investment. This can be explained by looking again at my example project A.
The variables in the equations stand for the following:
- PI is initial project investment
- NCF is positive net cash flow
- L is project life.
Where PI = £100 000, NCF = £135 000, and L = 5 years:
Expressed as a percentage return on the initial investment, this is 27% per year or
Activity 5 Average gross annual rate
Calculate the average gross annual rate of return on project B.
Expressed as a percentage return on the initial investment of £100 000, this is 32% per year.
If you compare project A and project B – as you might well do in real life – you see that project A gives the better payback period but project B offers the higher gross annual rate of return. Hence the recommendation never to use either of these methods alone. It is better to use both methods and then decide whether your main objective is quick payback or high rate of return in the longer term.
When you have arrived at the average gross annual rate of return for a project, you then compare that rate with the interest rate you would have to pay on any money that you borrowed to finance the project. If the rate of return exceeds the financing cost rate, you can proceed with the project. If it does not, you should either try to find a cheaper source of finance or not proceed with the project.