The rate of return (ROR) is presented as a percentage of the gain or loss of a particular project or investment in a specific time. In other words, it means getting the biggest profit from one’s investment (Arrow & Kurz, 2013). Indeed, it calculates the possible return that a firm is likely to get after carrying out a particular project.
Although annual and present worth can be calculated easily, many organizations prefer using the ROR. In particular, it is the most popular tool of analysis for determining project feasibility. The ROR calculates the possible return that a certain project can yield within a specific period. For this reason, firms use it to decide whether they should take a particular or not.
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If a firm lacks the money of investing in all positive discounted projects, it can use the ROR calculations to determine the most profitable project. In essence, by using the ROR, an organization can know the project has that a high return (Arrow & Kurz, 2013). As such, the firm can fund that project and leave others until it gets enough funds.
In some cases, the ROR generates multiple results. However, the only way that one can explain this occurrence to the management team is showing that cash flow changes affect the ROR calculations. For this reason, when comparing projects, it would be better for a company to use the net present value (NPV).
One can resolve the problem of getting multiple ROR by determining the internal return rate (IRR). The IRR can as well be used to assess the profitability of a particular investment (Arrow & Kurz, 2013). Specifically, it sets the NPV of a project to zero. Since the IRR uses a similar formula to that NPV, it enables one to get a reliable outcome.
Reference
Arrow, K. J., & Kurz, M. (2013). Public investment, the rate of return, and optimal fiscal policy. New York, NY: The Johns Hopkins University Press.
