Attribution Non-Commercial (BY-NC)

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Attribution Non-Commercial (BY-NC)

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Return on Investment (ROI) analysis is one of several commonly used financial metrics for evaluating the financial consequences of business investments, decisions, or actions. ROI analysis compares the magnitude and timing of investment gains directly with the magnitude and timing of investment costs. A high ROI means that investment gains compare favorably to investment costs. In the last few decades, ROI has become a central financial metric for asset purchase decisions (computer systems, factory machines, or service vehicles, for example), approval and funding decisions for projects and programs of all kinds (such as marketing programs, recruiting programs, and training programs), and more traditional investment decisions (such as the management of stock portfolios or the use of venture capital).

The ROI Concept and the Meaning of Return on Investment Explained With an Example

Most forms of ROI analysis compare investment returns and costs by constructing a ratio, or percentage. In most ROI methods, an ROI ratio greater than 0.00 (or a percentage greater than 0%) means the investment returns more than its cost. When potential investments compete for funds, and when other factors between the choices are truly equal, the investmentor action, or business case scenariowith the higher ROI is considered the better choice, or the better business decision. One serious problem with using ROI as the sole basis for decision making, is that ROI by itself says nothing about the likelihood that expected returns and costs will appear as predicted. ROI by itself, that is, says nothing about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the results hoped for. (The same is also true of other financial metrics, such as Net Present Value, or Internal Rate of Return). For that reason, a good business case or a good investment analysis will also measure the probabilities of different ROI outcomes, and wise decision makers will consider both the ROI magnitude and the risks that go with it. Decision makers will also expect practical suggestions from the ROI analyst, on ways to improve ROI by reducing costs, increasing gains, or accelerating gains (see the figure above).

Return on investment is frequently derived as the return (incremental gain) from an action divided by the cost of that action. That is simple ROI, as used in business case analysis and other forms of cash flow analysis. For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time?

Simple ROI is the most frequently used form of ROI and the most easily understood. With simple ROI, incremental gains from the investment are divided by investment costs. Simple ROI works well when both the gains and the costs of an investment are easily known and where they clearly result from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment.

ROI and other financial metrics that take an investment view of an action or investment compare investment returns to investment costs. However each of the major investment metrics (ROI, internal rate of return IRR, net present value NPV, and payback period), approaches the comparison differently, and each carries a different message. This section illustrates ROI calculation from a cash flow stream for two competing investments, and the next section ( ROI vs. NPV, IRR, and Payback Period) compares the differing and sometimes conflicting messages from different financial metrics. Consider two five-year investments competing for funding, Investment A and Investment B. Which is the better business decision? Analysts will look first at the net cash flow streams from each investment. The net cash flow data and comparison graph appear below.

Two aspects of the data are apparent at once: (1) Investment A has the greater overall net cash flow for the five year period, but (2) the timing of cash flows in each case is quite different. The differences in timing are even more apparent in a graphical representation of net cash flow:

To answer the question, "Which is the better business decision for the company?" the analyst will want to examine both investments with several financial metrics, including ROI, NPV, IRR, and Payback period. In order to calculate ROI, the analyst needs to see both cash inflows and cash outflows for each period (year) as well as the net cash flow. The tables below show these figures for each investment, including also cumulative cash flow and Simple ROI for the investment at the end of each year.

Simple ROI for each investment, in each period is shown in the bottom row of each table. Applying the cash flow ROI formula above to these data, the ROI for, say, Year 3 of Investment B is given as

Using simple ROI as the sole decision criterion, which investment is the better business decision? The answer here is: that depends on the time period in view.

y y

Considering the 3-year ROIs from each investment, clearly B's ROI of 35.9% is better than A's ROI of 5.7%. Considering the 5-year ROIs however, investment A clearly has the higher ROI at 62.2%, vs. 51.1% for B's five-year ROI. The example illustrates two important considerations to keep in mind when using ROI for decision support:

1. For most business investments there is not a single ROI for the investment, independent of the time period. Because business investments typically bring financial consequences extending several years or more, the investment can have a different ROI every year (or other period). The investment's ROI is not defined, that is, until the time period is stated. 2. The standard advice usually repeated when ROI is explained (as above) is: this: "Other things being equal, the investment with the higher ROI is the better business decision." However, important business decisions are rarely made on the basis of one financial metric and with business investments, moreover, the condition "other things being equal" almost never applies. When comparing investments with ROI, it is usually a very good idea to consider other financial metrics as well (as illustrated in the following section). As a final consideration in calculating ROI, note that some financial specialists prefer to derive ROI from cash flow stream present values. In investment situations, this typically leads to a lower ROI than the ROI from the non discounted cash flow. That is because the larger investment costs usually come early, and the larger gains appear later, so that discounting impacts the future gains more heavily than the future costs. In the "early costs / later gains" situation, using discounted cash flow figures to calculate ROI leads to a more conservative, less optimistic result. There are "pros" and "cons" to both the discounted and non discounted approach to ROI, and the business analyst should be sure to understand which approach is preferred by the organization's financial officers, and why.

The different natures of investments A and B are also apparent in a line graph of the cumulative cash flow for each (cumulative cash flow for a period is the sum of all net cash flows through the end of the current period). This is the fourth data row in each table above. Cumulative cash flow and payback are explained

4

more fully in the encyclopedia entry for payback period). In fact, some people call a cumulative cash flow graph, such as this one, a return on investment curve.

Which investment, A or B, is the better business decision? In this section, you should see that each investment has points in its favor, compared to the other, and that ultimately decision makers will have to weigh ROI results along with several other metrics, to decide which is best for their organization at the present time. Here are some of the points to consider:

y y

ROI: Investment A has the higher 5-year ROI (62.2% for A vs. 51.1% for B). That is a point in A's favorif the time period in view is 5 years. Future Performance: The cumulative curves above only cover 5 years, but if the investments inflows and outflows are expected to continue beyond 5 years, the curves point to two different futures. By Year 5, A's cumulative cash flow curve is heading skyward, while B's appears to be leveling off. If there is reason to believe these patterns will continue, this is also a point in favor of A. Payback Period. The cumulative cash flow curves above show roughly the point in time when the cumulative cash flow "breaks even," that is, when cumulative incoming returns exactly balance cumulative outflows. This point in time (point on the horizontal axis) is Payback period for each investment (see payback period). The payback period for B is 1.5 years, while A's payback period is 3.14 years. Investment B "pays for itself" in half the time of investment A. The shorter payback period is preferred because it means invested funds are recovered sooner, and available for use again sooner. The shorter payback period is also viewed as less risky than the longer payback. These are points in favor of investment B. Net present value (NPV): Using a 10% Discount rate, Investment B has a net present value (NPV) of 76.18, while A's NPV is 70.51. With the time value of money rationale, this means that investment B is worth more, today, than investment A, even though A will ultimately (in 5 years) return more funds. This is a point in favor of B. Internal rate of return (IRR): Internal rate of return (IRR) is the interest rate that produces an NPV of 0 for a cash flow stream (see Internal rate of return for a complete overview of what this means and why it can be important). Investment A has an IRR of 28.9% while B's IRR is 44.9%. Roughly speaking, financial officers will view a potential investment with an IRR above their cost of borrowing as a net gain. When investments are competing for funds, of course, the higher IRR is preferred. This is a point in favor of investment B.

Based on the financial metrics reviewed above, which investment, A or B, is the better business decision? Clearly there is no "one size fits all" answer, except to say that ROI is one factor decision makers and planners will consider, but they will consider other factors as well and give different "weights" to the different financial metrics above, based on (a) the company's business objectives, and (b) the current situation.

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