The investment projects businesses undertake
- New machinery: a business buys equipment to make more units, make them faster, or make them at a lower cost per unit, in the way JCB installs a new production line or a bakery replaces a worn oven.
- Buildings: Greggs fitting out another shop, or a manufacturer adding a warehouse, spends heavily now to reach more customers or hold more stock later.
- Vehicles: a wholesaler buying delivery vans can serve customers further away, and can control its own deliveries instead of paying a courier.
- All three share the same shape. One large payment leaves the business at the start, and the profit it is supposed to earn is spread across several future years, all of it forecast rather than known.
- So the owner needs a single figure that sets the size of the return against the size of the outlay, and the average rate of return does exactly that.
Note
Investment here means spending on things the business will use for years, such as machinery, premises and vehicles, not the everyday spending on wages and raw materials.
Calculating the average rate of return
Definition
Average rate of return: the average annual profit an investment earns, expressed as a percentage of what the investment cost to buy.
- Getting there takes two formulae, and neither of them is supplied in the exam, so both have to be learnt.
- First flatten the whole project into one typical year, by sharing the total profit equally across the years the investment will last.
- Then turn that yearly profit into a percentage of the sum paid at the start, which is the step that makes projects of different sizes comparable.
Example
- Stonegate Coffee, which runs three coffee shops in York, is considering a roasting machine costing £40,000.
- The roaster is forecast to earn £60,000 of extra profit across its five-year life.
- The roaster's figures go through the two formulae in that order.
- So every £1 Stonegate puts into the roaster brings back an average of 30p of profit a year.
- The machine earns £60,000 on a £40,000 outlay, so it more than repays its cost within the five years, and 30% is far above anything a bank would pay on the same £40,000 sitting in a savings account.
Common Mistake
- Divide by the number of years first, because feeding the total £60,000 straight into the second formula gives 150% instead of 30%.
- The cost of investment is the sum paid at the start, so keep it separate from any year's profit figure.
Comparing two projects
- Stonegate can only afford one project this year, and the alternative is a delivery van costing £25,000 that should earn £28,000 of profit over the same five years.
- Because the answer is a percentage rather than an amount of money, projects of different sizes can be compared fairly, so the £25,000 van and the £40,000 roaster can be judged side by side.
Example
- The van costs £25,000 and is forecast to earn £28,000 of profit over five years.
- Each pound put into the van brings back 22.4p of profit a year, quoted to one decimal place.
| Project | Cost of investment | Total profit over five years | Average annual profit | Average rate of return |
|---|---|---|---|---|
| Roasting machine | £40,000 | £60,000 | £12,000 | 30% |
| Delivery van | £25,000 | £28,000 | £5,600 | 22.4% |
Note
- On the numbers alone the roaster wins, because each pound invested in it works harder: 30p a year against 22.4p a year.
- The van still earns more than a savings account would, so neither project is a waste of money, but the roaster uses Stonegate's cash more productively.
Why the higher percentage is not automatically the better choice
- Risk: both percentages rest on forecast profits. If the roaster's 30% assumes Stonegate can sell far more coffee than it does today, a safer 22.4% from the van may be worth more than an optimistic 30%.
- How long the money is tied up: once £40,000 is locked into a roaster for five years it cannot mend a roof or carry the business through a quiet January, so a firm short of cash may take the cheaper van despite its lower return.
- The timing of the profit is invisible. Because the calculation averages the years, a project earning most of its profit in year one and one earning most of it in year five can show exactly the same average rate of return, even though the first hands the cash back much sooner.
- Non-financial factors: the van may be the only way to keep the three shops supplied, and the roaster may cut waste and improve the coffee, and neither of those shows up anywhere in the percentage.
Example
- Stonegate's owner buys the van, even though its 22.4% is the weaker figure, because without it the three shops cannot be supplied at all.
- The 30% roaster stays on the list for next year, when there is more spare cash to tie up in it.
Self review
- Name three kinds of investment project a business might undertake.
- How do you turn a project's total profit over its life into its average annual profit?
- A £50,000 machine earns £8,000 of average annual profit: what is its average rate of return?
- Give two reasons a business might pick the project with the lower percentage.
- What does this calculation tell you nothing about, even when two projects share the same percentage?
