Simple Rate of Return is the ratio of net profit in a normal year to the initial investment in terms of fixed and working capital. If one is interested in equity alone the profitability of equity can be calculated. The simple rate of return could be presented as, 3
R = (F+Y)/I Re = F/Q
where R = Simple rate of return on total investment;
Re = Simple rate of return on equity capital
F = Net profit in a normal year after depreciation, interest and taxes;
Y = Annual interest charges; I = Total investment comprising of equity and debt;
Q = Equity capital invested.
•Normal year is a representative year in which capacity utilization is at technically maximum feasible level and debt repayment is still under way.
•The simple rate of return helps in making a quick assessment of profitability, particularly projects with short life.
•Its shortcoming is that it leaves out the magnitude and timing of cash flows for the rest of the years of a project’s life.
•For evaluation, accurate data is required. In its absence simple rate of return may be incorrect.
•Simple rate of return method is suitable for financial analysis of existing units. It is not suitable for optimizing investment.
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