Scribd
Upload
364 views3 pages

Rate of Return Method

The rate of return method compares investment project alternatives by calculating the rate of return for each project. The rate of return is the interest rate at which the present worth of a project's cash flows equals zero. The project with the highest rate of return is selected as the best alternative. An example calculates the rate of return for a new business project with an initial investment of Rs. 100,000 and annual revenue of Rs. 30,000 over 5 years by finding the interest rate at which the net present worth equals zero.

Uploaded by

utcm77
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
364 views3 pages

Rate of Return Method

The rate of return method compares investment project alternatives by calculating the rate of return for each project. The rate of return is the interest rate at which the present worth of a project's cash flows equals zero. The project with the highest rate of return is selected as the best alternative. An example calculates the rate of return for a new business project with an initial investment of Rs. 100,000 and annual revenue of Rs. 30,000 over 5 years by finding the interest rate at which the net present worth equals zero.

Uploaded by

utcm77
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
You are on page 1/ 3

Rate of return method

Inmostofthepracticaldecisionenvironments,executiveswillbeforcedtoselect
thebestalternativefromasetofcompetingalternatives.

Let us assume that an organization has a huge sum of money for potential
investmentandtherearethreedifferentprojectswhoseinitialoutlayandannual
revenues during their lives are known. The executive has to select the best
alternativeamongthesethreecompetingprojects.

Thereareseveralbasesforcomparingtheworthinessoftheprojects.Thesebases
are:
1. Presentworthmethod
2. Futureworthmethod
3. Annualequivalentmethod
4. Rateofreturnmethod

RATEOFRETURNMETHOD

Therateofreturnofacashflowpatternistheinterestrateatwhichthe
presentworthofthatcashflowpatternreducestozero.
In this method of comparison, the rate of return for each alternative is
computed. Then the alternative which has the highest rate of return is
selectedasthebestalternative.
Ageneralizedcashflowdiagramtodemonstratetherateofreturnmethodof
comparisonispresentedinFig

In the above cash flow diagram,Prepresents an initial investment,Rjthe net


revenueattheendofthejthyear,andSthesalvagevalueattheendofthenthyear.

Thefirststepistofindthenetpresentworthofthecashflowdiagramusingthe
followingexpressionatagiveninterestrate,i.
PW(i)=P+R1/(1+i)1+R2/(1+i)2+...+Rj/(1+i)j+...+Rn/(1+i)n+S/(1+i)n
EXAMPLE
Apersonisplanninganewbusiness.Theinitialoutlayandcashflowpatternfor
thenewbusinessareaslistedbelow.Theexpectedlifeofthebusinessisfiveyears.
Findtherateofreturnforthenewbusiness.

Solution
Initialinvestment=Rs.1,00,000Annualequalrevenue=Rs.30,000Life=5years
ThecashflowdiagramforthissituationisillustratedinFig.

Fig.Cashflowdiagram.
Thepresentworthfunctionforthebusinessis
PW(i)=1,00,000+30,000(P/A,i,5)
Wheni=10%,

PW(10%) =1,00,000+30,000(P/A,10%,5)
= 1,00,000+30,000(3.7908)
= Rs.13,724.
Wheni=15%,
PW(15%) =1,00,000+30,000(P/A,15%,5)
= 1,00,000+30,000(3.3522)
= Rs.566.

Wheni=18%,
PW(18%) =1,00,000+30,000(P/A,18%,5)
= 1,00,000+30,000(3.1272)
= Rs.6,184

i=15%+0.252%=15.252%
Therefore,therateofreturnforthenewbusinessis15.252%.

You might also like