Return on Investment

Topics: Net present value, Rate of return, Internal rate of return Pages: 11 (2285 words) Published: February 10, 2011
Return On investment

The ROI Concept 6
Simple ROI for Cash Flow and Investment Analysis 7
Competing Investments: ROI From Cash Flow Streams 7
ROI vs. NPV, IRR, and Payback Period 10
Other ROI Metrics 11

Table 1 6
Table 2 7
Table 3 8
Table 4 8
Table 5 8
Table 6 ………………………………....................... 9 Table 7 ………………………………...................... 10 Return on Investment: What is ROI analysis?

Return on Investment (ROI) analysis is one of several commonly used approaches for evaluating the financial consequences of business investments, decisions, or actions. ROI analysis compares the magnitude and timing of investment gains directly with the magnitude and timing of investment costs. A high ROI means that investment gains compare favorably to investment costs.

In the last few decades, ROI has become a central financial metric for asset purchase decisions (computer systems, factory machines, or service vehicles, for example), approval and funding decisions for projects and programs of all kinds (such as marketing programs, recruiting programs, and training programs), and more traditional investment decisions (such as the management of stock portfolios or the use of venture capital).

The ROI Concept

Most forms of ROI analysis compare investment returns and costs by constructing a ratio, or percentage. In most ROI methods, an ROI ratio greater than 0.00 (or a percentage greater than 0%) means the investment returns more than its cost. When potential investments compete for funds, and when other factors between the choices are truly equal, the investment—or action, or business case scenario—with the higher ROI is considered the better choice, or the better business decision.

One serious problem with using ROI as the sole basis for decision making, is that ROI by itself says nothing about the likelihood that expected returns and costs will appear as predicted. ROI by itself, that is, says nothing about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the results hoped for. (The same is also true of other financial metrics, such as Net Present Value, or Internal Rate of Return). For that reason, a good business case or a good investment analysis will also measure the probabilities of different ROI outcomes, and wise decision makers will consider both the ROI magnitude and the risks that go with it.

Decision makers will also expect practical suggestions from the ROI analyst, on ways to improve ROI by reducing costs, increasing gains, or accelerating gains (see the figure above).

Simple ROI for Cash Flow and Investment Analysis

Return on investment is frequently derived as the “return” (incremental gain) from an action divided by the cost of that action. That is “simple ROI,” as used in business case analysis and other forms of cash flow analysis. For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time?

Simple return on investment ROI
Simple ROI is the most frequently used form of ROI and the most easily understood.

With simple ROI, incremental gains from the investment are divided by investment costs.

Simple ROI works well when both the gains and the costs of an investment are easily known and where they clearly result from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment.

Competing Investments: ROI From...
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