The rate at which profit is earned, the rate of return, is the key factor in investments. It is described and used in exactly the same way as a compound interest rate. Usually, it is stated as an annual rate of return (a rate compounded annually, an effective rate). As in the usual calculation of compound interest, the rate of return is applied to the outstanding balance (the unrecovered part of the investment). Once the investment has been recovered, all additional inflows represent profit beyond the minimum requirements.

We need a way to evaluate investments so that we can choose the best ones. The major methods of evaluation involve discounting cash flows to find their present values (values at the beginning of the investment).

There are several approaches to dealing with the rate of return. The first approach we shall consider is to set a minimum rate, called the minimum acceptable rate of return (MARR) or minimum return on investment (ROI).

If a company sets such a rate, then investments must meet or exceed this rate of return before the company will fund them. Consequently, the company’s resources will be directed to only those projects that provide adequate returns.

The setting of the minimum acceptable rate of return is a management decision and depends on a number of factors, including the company’s historical earnings rate and the cost of capital raised by the company.

 

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