Return on Investment (ROI) is defined as the ratio of money gained or lost relative to the amount of money invested on a project. The amount gained or lost is called the interest or profit whereas the investment is referred to as capital, asset or principal. More technically, it is found by dividing the Net Profit by Net Worth as is usually expressed as a percentage. It should be noted that return on investment might entail both profits and losses accrued on the asset invested in the past, present or future.
Return on investment can be calculated on past or current investment or on the estimated return on future investment. It does not indicate the period for which the investment is being made. Rate of Return, Return on Investment or Rate of Profit is essentially the future stream of income or a cash flow from an invested capital. This future stream of income or cash flow might arise from interest, dividends or capital gains. A capital gain occurs when the market value of an investment rises or falls. It does not however, include the returns accrued on the investment.
Arithmetically, the rate of return is symbolized as:
Vf/Vi –1, where Vf denotes final investment value and Vi is the initial investment value.
(Vf and Vi should be noted as subscripts)
Return on investment (ROI) is profitable when Vf/Vi-1>0 and the investment is deemed to be unprofitable when the value of final investment is less than that of the initial investment. ROI is calculated to be 1 or 100% when the value of the final investment is twice the value of the initial investment.
Yield is the return on investment if termed in a more dynamic sense. It is based on the compound interest rates calculated when the value of investment continuously changes over time. It captures the effect or reinvesting interest or dividends. Academics generally use natural log return or continuously compounded return for purposes of their research. Annual Percentage Yield (APY) or Effective Annual Rate (EAR) indicates annual yields if calculated using compound interest.
Return on investment calculated on annual or annualized rate of returns (return on investment over a period other than one year multiplied or divided by an adjusting factor to give a comparable one-year return) is essential for undertaking personal financial decisions. Personal investments can be risk-free such as savings accounts or certificates of deposit or capital investments such as stock, shares, mutual funds that are highly volatile in nature. Incomes from capital gains are also very fluctuating which can lead to losses on investments.
On corporate lines, return on investment is defined as the company’s ability to use its assets to generate additional income for its stakeholders. Returns on equity or return on assets are extensively used by financial analysts to calculate the profitability of the company vis-ŕ-vis other organizations. An internal rate of return, net present value or profitability index is calculated to choose risk-free projects, which would generate the maximum revenue for the shareholders. These analyses fall under the ambit of capital budgeting techniques. More risky investments have the potential for generating higher returns with a proportional case of running losses. In short, ROI depends on the capitalization policy, the rate of depreciation of the asset over time, lag between investment outlays and the recoupment of these outlays from subsequent cash inflows and the growth of new investment from faster growing companies.
Investment returns or returns on investments are discounted for taxes and inflation factors which can give the real worth of the investment returns. Investments generate cash flow to the investor, which compensates for the time value of money. As previously mentioned, the rate of return at which the investors would be willing to invest depends on future inflation rates, the risk associated with the investment, that is to say whether a regular flow of returns or dividends is guaranteed or whether returns are preferred in liquid assets.
Lastly, Return on Investment (ROI) is an important component of Cost-Benefit Analysis especially for Usability projects and those, which have far reaching consequences on the development of a region or a country. Investment returns calculated by potential foreign investors investing in infrastructural projects in less developed countries around the globe will be a relevant case study.