Rate of Return

Rate of return is expressed as a percentage of the total amount of an investment over a period of time (typically expressed on an annual basis). Unfortunately, different people may use this representation in different ways. You may hear rate of return expressed as the interest returned on an investment or the profit margin received over a defined period of time.

If an investment of $100,000 over one year of time yielded a balance of $110,000, then the rate of return would be $10,000. The rate of return would be expressed as 10% ($10,000 divided by $100,000 (initial investment) = 0.10 or 10%).

There are multiple types of calculations for “rate of return,” such as internal rate of return, tie-weighted rate of return, and so on—not to be confused with the basic rate of return just described. Many calculations take into consideration other factors such as time value of money, inflation, deflation, taxes, and other criteria that may be applicable for analysis. These should all be understood to the degree of how and why it affects the analysis being done. For example, if the 10% rate of return were adjusted for an annual 2% inflation, then the adjusted rate of return would be 8% (10% – 2% = 8%).

Uses of the rate-of-return calculation vary as well. Most often rate of return is used in evaluating investment criteria for future decisions and for measuring performance of current or past investments. For instance, a hospital is considering expansion to another location. The hospital has $20 million for the expansion in liquid assets. The decision has been made to go through with the project, because it is projected to pay for itself in five years and double the revenues of the hospital. Now the stakeholders are discussing how to pay for it. Should they use the $20 million, which is currently earning 9% (rate of return on the $20 million), or should they borrow the money at a 7% rate of interest (their cost of capital). If they used the current $20 million they would give up 2% (9% – 7% = 2%) on their potential earning power on the $20 million. So, they would be better off borrowing the money, and if the earning potential of the $20 million ever goes below the cost of capital (7%), then they would have the opportunity to pay the loan off.

The rate of return is a powerful tool in projecting and setting priorities on investments. Even if the preceding investment example had not met the exact criteria for the financial model, the hospital might have gone through with it anyway because it met the strategic goals and the opportunity costs for not doing now would have been greater later. Other investment decisions that have a negative rate of return may need to be accomplished as a necessity, such as a leaky roof. This tool can help in looking at the financial or resource investment aspects but should never be the sole criterion for a “wise” investment strategy.