Question

what are the three major financial methods to analyze and measure the returns on investment. Critique each by noting their relative theoretical strengths and weaknesses. How can each be valuable in some way to help financial professionals make good business decisions?

Answer 1

Meaning of Return on Investment -

Return on Investment measures the probability of gaining a return from a investment. It compares the gain or loss with respect to its cost incurred. It is useful in making business decisions evaluating the expected returns from a single investment as well as in comparing returns from several investments.

Three major financial methods to analyze and measure the returns on investment -

i) Standard Return on Investment

ROI = [ ( Final Value of Investment - Initial Value of Investment ) / Cost of Investment ] * 100

Strengths of Standard ROI -

• Simplest method of calculating ROI and is widely used.
• ROI can be dissected into component parts and distinguished between capital gains and dividends as they are taxed on different rates.

Weaknesses of Standard ROI -

• Does not consider the duration of holding the investment in calculations, thereby ignoring the compounding effect.
• Does not take into account the risks that are associated with an investment.
• Investments of different time duration cannot be compared.
• ROI figures can be exaggerated if all the expected costs are not included in the calculation.

Usage of Standard ROI -

Standard ROI method can be used when comparing two investments of the same duration. Once the total costs and total returns expected are considered, it provides an accurate picture helpful in making business decisions. A positive figure indicates that the returns exceed the costs and vice versa.

ii) Annualized Return on Investment

Annualized ROI = [ (1 + ROI)1/n - 1 ] * 100

wherein, n = number of years the investment is held

Strengths of Annualized ROI -

• Takes into consideration the duration of holding the investment.
• Investments with different duration periods can be compared easily.

Weaknesses of Annualized ROI -

• Does not take into account the risks that are associated with an investment.
• ROI figures can be exaggerated if all the expected costs are not included in the calculation.

Usage of Annualized ROI -

Annualized ROI is most useful when investment decisions have to be made with respect to investments of different durations, thereby mitigating the drawback of standard ROI. This method considers the compounding effect on the investments and brings them at the same level to be compared.

iii) Leveraged Return on Investment

When evaluating a business proposal, it's possible that you will be contending with unequal cash flows. In this scenario, ROI may fluctuate from one year to the next.

Leveraged ROI = [ (Final value of Investment - Initial Value of Investment) * Number of units + Dividends - Commissions - Interest on Margin Loan ] / [ Total Investment - Margin Loan ] * 100

Strengths of leveraged ROI -

• It is the most practical method amongst the three as it considers the aspect of margin loan and interest.
• ROI can be dissected into component parts and distinguished between capital gains and dividends as they are taxed on different rates.

Weaknesses of leveraged ROI -

• Does not take into account the risks that are associated with an investment
• Does not consider the duration of holding the investment in calculations, thereby ignoring the compounding effect.
• It amplifies the ROI if the investment generates gains or losses as compared to the other methods.

Usage of Leveraged ROI -

Leveraged ROI is most useful when the investor has made investments using margin loan taken from brokerage firms. All the costs and returns expected are considered and an accurate picture of the net returns is provided considering the leverage employed.

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