Rate of Return Defined
The Rate of Return (RoR) is a key metric used to gauge the profitability or efficiency of an investment. It refers to the annual income generated by investing resources into commercial or economic activities, typically expressed as a percentage of the initial investment amount. This figure provides investors with a simple measure to evaluate how effectively their capital is being utilized.
RoR encompasses various evaluation methods, depending on the context of the investment:
- Discounted Cash Flow (DCF): Often uses the Internal Rate of Return (IRR) to determine the RoR.
- Divisional or Subsidiary Investment: Commonly uses the Accounting Rate of Return (ARR) or Return on Capital Employed (ROCE) to express RoR.
Detailed Examples
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Internal Rate of Return (IRR):
- Example: If a project requires an initial investment of $100,000 and the net present value (NPV) of future cash flows discounted at a certain rate calculates to zero, this rate is termed the IRR. If the IRR is 10%, it indicates a 10% annual return on the invested capital.
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Accounting Rate of Return (ARR):
- Example: A department within a company requires $200,000 for new equipment expected to provide an annual profit of $20,000. The ARR is calculated as ($20,000 / $200,000) * 100%, resulting in a 10% ARR.
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Return on Capital Employed (ROCE):
- Example: A business division invests $500,000 in capital and generates an operating profit of $75,000. The ROCE is calculated by ($75,000 / $500,000) * 100%, yielding a 15% ROCE.
Frequently Asked Questions (FAQ)
What is a good rate of return on an investment?
A good RoR depends on various factors, such as the type of investment, market conditions, and risk tolerance. Generally, a RoR exceeding the risk-free rate, such as government bonds, is considered favorable.
How is RoR different from ROI (Return on Investment)?
RoR often refers to the annualized return percentage, while ROI considers the absolute return over the investment’s entire period.
Can RoR be negative?
Yes, RoR can be negative if the annual income earned from the investment is less than zero, indicating a loss relative to the original investment amount.
How does time affect Rate of Return calculation?
For investments over multiple years, compounding effects need to be considered, necessitating methods like IRR to accurately reflect the time value of money.
How do taxes impact RoR?
Taxes can significantly impact RoR. It’s essential to calculate both pre-tax and after-tax returns to gauge the investment’s true profitability.
Related Terms
- Internal Rate of Return (IRR): The discount rate that makes the NPV of cash flows from an investment equal to zero.
- Accounting Rate of Return (ARR): Measures the return on investment derived from accounting profit rather than cash flow.
- Return on Capital Employed (ROCE): A metric evaluating the profitability and efficiency of a company’s capital investments.
- Required Rate of Return (RRR): The minimum RoR an investor expects to achieve from an investment, given its risk profile.
Online References
- Investopedia: Rate of Return
- Investopedia: Internal Rate of Return
- Investopedia: Accounting Rate of Return
Suggested Books for Further Studies
- “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “The Intelligent Investor” by Benjamin Graham
Accounting Basics: “Rate of Return” Fundamentals Quiz
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