Simple rate of return
A term simple rate of return refers to a rate (ROR) which measures the increase or decrease in investment value over a period of time^{[1]} . The simple rate of return is probably the most commonly used capital budgeting method.
The method refers to the profit generated by the investment as a percentage of the investment. The most common variant of this method uses average return and average investment to obtain a more accurate analysis. It is also known as the unadjusted rate of return and the accounting rate of return ^{[2]}.
Calculation of ROR
The simple rate of return will be effective only if only one dividend is paid at the end of the period based on the measurement of investment performance. If dividends are paid more often or within a given period, the accuracy of the lines. The rate analysis, which determines the percentage or return on investment^{[3]}. The most common conjugation of this method is based on average return and average investment to obtain a more correct analysis. Simple rate of return can be calculated by^{[4]} :
It can be also calculated by using the following equal^{[5]} :
Where:
P_{1} - initial investment value
P_{2} - is the investment value at the end of the period
I - stands for the income earned during the investment
For example, an entrepreneur buys a bond at a price of $200 and is held for a year during which the coupon is paid out at $10 . At the end of the period, the bond price has increased to $220. In that case, the rate of return will be 15%. Determining the performance of a share or portfolio by means of a rate calculation is appropriate when income is earned at the end of the period. If dividends are paid during a period, a simple delay in reimbursement will have certain limitations^{[6]}.
Advantages and disadvantages of ROR
The main advantages of simple rate of return are as follow^{[7]} :
- Easy to understand and calculate
- It recognizes profitability
- The figures refer to the presentation of the financial statements
- Contemplate full useful life
The most important disadvantages are^{[8]} :
- Uses income data instead of cash flow data
- Ignores the value of money
Simple rate of return in companies
This method takes into account net profits throughout the entire estimated duration of the investment. It is easy to understand and in line with the ROE targets set by management. In practice, many companies have estimated ROE standards that have been set as a border point for many investment projects.
Unless the investment proposal exceeds these minimum standards, it will not be seriously considered. Range estimated from 15 to 25 percent are common for many food and agribusiness enterprises^{[9]}.
Rate of return adjustments
The adjusted rate of return takes into account the schedule of dividends and interest payments. Because the adjusted rate of return reflects the schedule of cash flows, it is also called a time-weighted rate of return. The rate of return assumes that all transitional cash flows are reinvested in the collateral under consideration ^{[10]}.
Difference between simple and actual rate of return
The difference between the initial (simple) and actual rate of return is simple, but the actual (internal) rate of settlement depends on the duration of the project and the extent of restrictions throughout the life cycle.
A simple rate of return is a useful criterion that can be easily calculated and then compared to the minimum desired rate of return on investment. The minimum rate of return is underlined because the actual rate of return is always lower than the usual initial rate of return, waiting for cost comparisons throughout the project's lifecycle. If a preliminary comparison is available that the simple rate of return is several percentage points above the minimum, then the project is available that is economically viable and may contain detailed analysis^{[11]}.
Examples of Simple rate of return
- The most common example of a simple rate of return is the annualized return on an investment. This is the rate at which an investment has increased or decreased in value over the course of a single year. For example, an investor who purchased a stock for $100 and sold it one year later for $120 would have an annualized return of 20%.
- Another example of a simple rate of return is the return on a bond. The return on a bond is the interest paid on the bond over a period of time, usually a year. For example, if an investor buys a bond with a face value of $1,000 and receives $50 in interest payments over the course of one year, then the return on the bond would be 5%.
- A third example of a simple rate of return is the return on a bank savings account. The return on a savings account is the interest rate paid by the bank on the money deposited in the account over a period of time, usually a year. For example, if an investor deposits $1,000 in a savings account and receives $10 in interest payments over the course of one year, then the return on the savings account would be 1%.
The Simple Rate of Return (ROR) measures the increase or decrease in investment value over a period of time. Other approaches related to ROR include:
- Total Return Rate (TRR): This measure takes into account both the capital gains and income generated from the investment over a period of time.
- Internal Rate of Return (IRR): This is a measure of the profitability of a given investment and takes into account the time value of money.
- Equity Rate of Return (ERR): This measure takes into account the amount of equity invested in a given investment and the return on that investment.
- Risk-Adjusted Return (RAR): This measure takes into account the risk associated with an investment and adjusts the return accordingly.
In summary, the Simple Rate of Return is a measure of the increase or decrease in investment value over a period of time and there are several other approaches related to ROR which take into account the additional factors such as income, equity, risk, and time value of money.
Footnotes
Simple rate of return — recommended articles |
Effective annual interest rate — Appraisal right — Net yield — Money-weighted rate of return — Profit factor — Free cash flow yield — Gordon Growth Model — Blended Rate — Net present value (NPV) |
References
- Choudhry M (2001), Bond and Money Markets: Strategy, Trading, Analysis , Elsevier, Woburn
- Choudhry M (2011), Bank Asset and Liability Management: Strategy, Trading, Analysis, John Wiley & Sons, New Jersey
- Grondzki W (2019), Mechanical and Electrical Equipment for Buildings, John Wiley & Sons, New Jersey
- Levy H (2002), Fundamentals of Investments, Pearson Education, Harlow
- Shim J (2007), Handbook of Financial Analysis, Forecasting, and Modeling, CCH, Chicago
Author: Jakub Stachów