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] : Failed to parse (syntax error): {\displaystyle ROR = Average Annual Return ÷ Average Investment }
It can be also calculated by using the following equal[5] : Failed to parse (syntax error): {\displaystyle R= P2 - P1 + 1 ÷ P1 }
Where:
P1 - initial investment value
P2 - 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].
Footnotes
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
