The simple rate of return is the incremental amount of net income expected from a prospective investment opportunity, divided by the investment in it. The simple rate of return is used for capital budgeting analysis, to determine whether a business should invest in a fixed asset (and any incremental change in working capital associated with the asset). For example, if there is an opportunity under which a business can earn an incremental increase in its net profit of $8,000 in exchange for an initial investment of $100,000, then the project has a simple rate of return of 8% (calculated as $8,000 incremental net income / $100,000 investment). You would then accept a project if the measure yields a percentage that exceeds a certain hurdle rate used by the company as its minimum rate of return.
Similarly, if a prospective project could result in a cost reduction (rather than incremental net income), then you would substitute the amount of cost savings for incremental net income in the calculation.
While this method has the advantage of being simple and easy to calculate, it also suffers from several problems, which are:
- Time value of money. The method does not use discounting to reduce the incremental amount of net income to its present value. Instead, it assumes that any net income earned during the measurement period is the same as its present value. This failing overstates the rate of return, especially for income that may be many periods in the future. Thus, the method assumes that net income earned several years from now has the same value as net income earned in the present.
- Cash flow. The method uses net income in the numerator of the calculation, rather than cash flows. Cash flows are considered the best method of judging the return on an investment, whereas a variety of adjusting entries and non-cash transactions could alter the amount of net income to be a figure substantially different from cash flows. An example of a non-cash item that impacts net income is depreciation, which is not included in a cash flow analysis.
- Constant profit stream. The method assumes that you earn the same amount of incremental net income in period after period, when in reality this amount will probably change over time.
- Constraint analysis. The method does not factor in whether or not the capital project under consideration has any impact on the throughput of the company's operations.
The problems enumerated here make the simple rate of return an excessively simplistic method to use for judging a capital budgeting request. Instead, consider such other techniques as net present value analysis and throughput analysis (see the Related Topics section below).
The simple rate of return is also known as the unadjusted rate of return and the accounting rate of return.