How to Calculate Return on Investment

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Return on Investment or ROI is the measure of the amount of return received on an investment relative to its cost. In other words, ROI is the measure of the increment of an investment as regards the investor. To give an example, if you invest your money in government bonds then the amount of interest you receive on the amount invested is your ROI. This is the simplest way in which you can understand the concept of Return of Investment. 

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Return on Investment ROI

Concept and Example

If we were to take this discussion further, we would see that Return on Investment is calculated by comparing the total gains from an investment to the cost of investment and is always expressed as a percentage of the latter. To take our previous example of interest on government bonds:

Assume, that you invested Rs1, 00, 000 in Govt. bonds to be repaid to you in one year as Rs 1, 50, 000.

So, ROI = (Gain from the Investment−Cost of the Investment) ÷ (Cost of the Investment)

             = (Rs1, 50, 000−Rs1, 00, 000) ÷ Rs1, 50, 000

= Rs50, 000 ÷ Rs1, 50, 000

= 0.3333

= 33.33%, which is also known as the interest rate in this case.

Basically, ROI calculation requires one to possess a basic understanding of Gross Profit and Gross Revenue. ROI Is calculated with regard to Gross Profit from the investment and not Gross Revenue. In this example, the gross revenue was Rs1, 50, 000 while the gross profit was (Rs1, 50, 000−Rs1, 00, 000). On the other hand, the cost of investment includes all costs such as brokerage, implicit costs of time and other expenses that can be charged to the investment.

 

Difficulties in Calculation of Return on Investment

The above example is primarily a simple one. The complications in the calculation of ROI are increased manifold when the return from investment are to be received over a number of years instead of after a year of initial investment. Again, in some cases, the returns might start to accrue after a number of interceding years- as is often the case with projects having long gestation periods. Thus, while calculating ROI over a number of years one has not only to account for the years themselves, but also for the time value of money. The more considerations are added, the more accurate is the result and the calculations become difficult by so much.

 

Benefit of Calculating Return on Investment

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The prime reason for calculating ROI is to measure the objective amount of gains as against the cost of investment. Once the objective measure is determined, subjective analysis might be made with the same. Comparing the ROI from different alternative investment plans results in the determination of the best possible investment decision. The higher the ROI, the more favorable is the investment alternative. This analysis is done around the world both in organizations and on an individual level. ROI calculation is highly popular around the world on account of its simplicity, volatility and ease of understanding by laymen.

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