86 Simple Rate of Return
Learning Objectives
- Describe the simple rate of return method
The simple rate of return is calculated by taking the annual incremental net operating income and dividing by the initial investment. When calculating the annual incremental net operating income, we need to remember to reduce by the depreciation expense incurred by the investment.
WATCH IT
Let’s take a look at an example.
Hupana Running Company is looking at adding a stitcher that will add $40,000 to the revenues of the company per year. The incremental (additional) cash operating expenses of this piece of equipment would be $5,000 per year, and the equipment has a cost of $100,000 with a 5 year life and no salvage value. So let’s pop these numbers into the formula:
| Hupana Running Company—Stitcher Purchase | |
|---|---|
| Annual incremental revenue | $40,000 |
| Annual incremental operating expense | $5,000 |
| Annual depreciation ($100,000/5 years) | $20,000 |
| Annual incremental expenses | $25,000 |
| Annual incremental net operating income/(loss) | $15,000 |
So the simple rate of return would be: annual incremental net operating income/ initial investment cost
$15,000/$100,000= 15% simple rate of return
So it looks like the stitcher would be a good investment! What if we change up the numbers a bit. The stitcher will still add the $40,000 to revenues, but will add $10,000 to annual operating costs and only have a useful life of three years.
| Hupana Running Company—Stitcher Purchase | |
|---|---|
| Annual incremental revenue | $40,000 |
| Annual incremental operating expense | $10,000 |
| Annual depreciation ($100,000/ years) | $33,333 |
| Annual incremental expenses | $43,333 |
| Annual incremental net operating income/(loss) | −$3,333 |
We now have a negative rate of return, so would probably pass on making this purchase. This brings home the point of how important it can be to know your numbers and do your research! Also noting, a small difference, can make a huge difference in the decision to make a capital budgeting decision, so as a manager, be clear on your information and perhaps use several of the available methods before making a final decision or before taking your analysis to your supervisor!
LEARN MORE
For additional practice look at this exercise on the simple rate of return method.
