MONEY 119 - RATES OF RETURN

THIS IS MY 119^TH BLOG ON UNDERSTANDING MONEY TOOLS.

In this blog we are going to cover the basics of return on investment that most people who get into business should understand.  Why get into a business before you know the basics of returns and what to expect from your business plan and proforma?

In previous blogs we discussed the simple and quick compounded interest Rules of 7 and 10 based upon 72.  Quickly, this means that if you expect your investment to double in 7 years, it will be at a compounded interest of 10%.  Similarly, if you expect to double your money compounded in 10 years you will be making 7% on your money.  The 72 I make mention to above is just a bit more accurate as you divide 72 by the rate of return and that will give you the number of years before you double your money.

One element missing here is inflation eroding the original amount of money.

Let’s now discuss rates of return and internal rates of return.  For rate of return it is quite simple.  You merely divide the profit (or perhaps loss) by the original amount invested.  Let’s say you invest $100,000 for one year and at the end of the year you sell for $125,000.  That leaves a profit of $25,000.  To convert that amount into return on investment simply divide the $25,000 by the original investment of $100,000 and you will get .25.  Now, to convert that figure into a percentage return on investment merely multiply times 100 or move the decimal point two places to the right.  You get 25%.  That is the return on investment, exclusive of the impact of inflation, depreciation of an asset, etc.

In two businesses I have been closely involved in, the oil/gas business and commercial real estate/land development we use “internal rates of returns” (IRR’s), as it is closer to reality.  Why is this?  In both businesses you can invest significant money with losses for a few years, and then hopefully make a great deal of money.  Therefore, until you see all the figures you don’t know what a return might look like on an annualized basis. (Again, for simplification we are going to omit inflation, depreciation of the assets, taxes and any depletion allowances the government might give as in the oil/gas industry.)  This is also known as a discount rate or economic rate of return.

In calculating an internal return there is a formula to follow which is not too complicated and you can put to memory: NPV=CF divided by (1+ Interest Rate times N).  NPV equals net present value, CF is cash flow, Interest Rate is your objective rate of return, and N is the number of years it takes you.  Ouch!  Let’s make some sense of this.  We have a situation where we have a number of cash flows (CF’s) into the project being negative in perhaps early years and positive later on down the line.  The objective with this formula is to bring the NPR (net present value) back to zero.  NPV is on the left of the equal sign.  Assume you want a 10% overall return on investment.

Without a calculator this takes some guessing and experimentation.  Let’s say you take $7,000 and start your business.  The first year you lose $2,000, the second year you lose $1,000, however the third year you make $12,000.  That has returned a positive Cash Flow (CF) of $9,000.  Now, going back to the formula I gave you above you are going to also use the N, number of years, or in this case three.

Let’s put this together.  NPV is $7,000.  CF, or $9,000, divided by 1 plus 10% (.10) times 3.  I’m far from being smart but I do know that .10 times 3 is .30.  Now take 1.30 and divide that number into CF or in this case $9,000.  On my phone calculator it shows me $6,923.  Wow, that is close enough for me to $7,000, and that gets me close to my goal of zero.  Therefore, in the case above my internal rate of return for my little business has been 10% for a three year period including both losses and profit.

See you next time.