How to calculate return on investment (ROI): formula, investment project assessment, profit calculation

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How to calculate return on investment (ROI): formula, investment project assessment, profit calculation
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Return on investment (ROI) is an index that shows the relationship between costs and the planned profit of a project.

Calculation and evaluation of return on investment

This indicator is calculated:

PI = NPV / IC

  • PI (Profitability Index) – index of profitability of an investment project;
  • NPV (Net Present Value) – net present value;
  • IC (Invest Capital) – initial investment capital spent.

If the profitability index is 1, this is the lowest acceptable indicator. Any value below 1 indicates that the project’s net profit is less than the initial investment. As the index value increases, the financial attractiveness of the proposed project also increases.

ROI
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The profitability index is a valuation method applied to potential capital expenditures. This method divides the projected capital inflow by the projected capital outflow to determine the profitability of the project. The main feature of using the profitability index is that the method ignores the scale of the project. Therefore, projects with large cash inflows may show lower index values ​​in calculations because their profits are not as high.

NPV – Net investment value or net real (present) value of investment

NPV = PV – Io

  • PV – current value of cash flow;
  • Io – initial investment.

The above NPV formula shows cash income in a simplified way.

Calculating the planned net cost of investing in an enterprise is quite difficult. This is due to the fact that money depreciates over time (inflation occurs). Therefore, $1 earned now cannot be equated to $1 received in a year. In order to compare the received profit with the predicted one, you will need to use the indexation coefficient.

When investing, it is believed that the faster that same $1 is earned, the more valuable it will be than the profit received in the future.

Calculation of future profit of an investment project:

  • I is the amount of investment in the t-th year;
  • r – discount rate;
  • n – investment period in years from t=1 to n.

Investment amount: initial investment and additional capital costs

Discounted projected cash outflows represent the initial capital costs of the project.

The initial investment is only the cash flow required to start the project.

All other costs may occur at any time during the life of the project and are included in the calculation using the enterprise’s discounted net profit. These additional capital costs may impact tax or depreciation benefits.

Decision making – Return on investment index

The Return on Investment Index (PI) should not be less than one. If this is so, then it is necessary to create conditions for its increase.

ROI
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  • PI > 1.If the indicator exceeds one, this indicates that expected future cash inflows exceed projected discounted cash outflows.
  • PI < 1. A value less than one indicates that spending will be more than the projected profit. In this case, you should not run this project.
  • PI = 1. A value of one indicates that any profits or losses from the project are minimal. Therefore, the project will not attract the attention of investors.

When using the profitability index, projects whose value is more than one are considered.

EBITDA – Earnings before interest, taxes, depreciation and amortization
EBITDA – Earnings before interest, taxes, depreciation and amortization
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Editorial team
Editorial team of Pakhotin.org

When investors have limited capital and there are several projects under consideration, the option with the highest profitability is accepted. Because it indicates the project with the most productive use of limited capital.

For this reason, the cost-benefit index is also called the benefit-cost ratio. Although some projects have a higher net present value, they may still not be selected because they do not have the highest profitability index and do not represent the most profitable use of the company’s assets.

Interesting facts about investments

Gold is an eternally profitable investment!

Investing in gold has been relevant throughout human history. This precious metal always has a high profitability ratio.

The name does not mean benefit!

As a rule, the most stable and profitable investments come from companies that produce everyday products. And high-tech innovative organizations can often only bring losses.

Wealth is the right investment!

Most owners of large companies and networks invest their savings in investments. In this way, they protect themselves from possible adverse situations.

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Anatoly Vorobiev
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