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    Rate of Return Method

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    utcm77
    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.

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    Rate of Return Method

    Uploaded by

    utcm77
    258 views3 pages
    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.

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    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.

    Copyright:

    © All Rights Reserved
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    258 views3 pages

    Rate of Return Method

    Uploaded by

    utcm77
    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.

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    © All Rights Reserved
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    of 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%.

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