Difference between revisions of "Simple rate of return"

 
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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<ref>Choudhry M (2001)</ref> .
 
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<ref>Choudhry M (2001)</ref> .
 
The '''''simple rate of return''''' is probably the most commonly used capital budgeting method.
 
The '''''simple rate of return''''' is probably the most commonly used capital budgeting method.

Revision as of 16:36, 22 May 2020

Simple rate of return
See also

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] \[ ROR = Average Annual Return ÷ Average Investment \]

It can be also calculated by using the following equal[5] \[ R= P2 - P1 + 1 ÷ P1 \]

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

  1. Choudhry M (2001)
  2. Shim J (2007)
  3. Choudhry M (2001)
  4. Shim J (2007)
  5. Choudhry M (2001)
  6. Levy H (2002)
  7. Shim J (2007)
  8. Shim J (2007)
  9. Barnard F (2012)
  10. Levy H (2002)
  11. Grondzki W (2019)

References

Author: Jakub Stachów