rate of return

Examples of rate of return in the following topics:

• Return on Investment

  • The purpose of the "return on investment" metric is to measure per-period rates of return on dollars invested in an economic entity.
  • ROI is often compared to expected (or required) rates of return on dollars invested.
  • Return on investment = (gain from investment - cost of investment) / cost of investment
  • Complex calculations may also be required for property bought with an adjustable rate mortgage (ARM) with a variable escalating rate charged annually through the duration of the loan.
  • (To know more about ARM, check out: Mortgages: Fixed-Rate Versus Adjustable-Rate. )

• Cost-Based Pricing

  • This approach sets prices that cover the cost of production and provide enough profit-margin to the firm to earn its target rate of return.
  • This method, although simple, has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.
  • However, the process of obtaining this additional information is expensive.
  • There are several varieties, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup.
  • Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the firm to earn its target rate of return.

• Stability Through Fiscal Policy

  • Governments can use fiscal policy as a means of influencing economic variables in pursuit of policy objectives.
  • The argument mostly centers on crowding out, a phenomenon where government borrowing leads to higher interest rates that offset the stimulative impact of spending.
  • When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets.
  • This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return.
  • In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return.

• Equity Finance

  • The stock of a business is divided into multiple shares, the total of which must be stated at the time of business formation.
  • In finance, the cost of equity is the return, often expressed as a rate of return, a firm theoretically pays to its equity investors, (i.e., shareholders) to compensate for the risk they undertake by investing their capital.
  • Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
  • While a firm's present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated.
  • If an investment's risk increases, capital providers demand higher returns or they will place their capital elsewhere.

• Pay Systems

  • In return, he is expected to maintain a very high level of performance, both quantitative and qualitative.
  • Measured Day Work: According to this method, the hourly rate of the time worker consists of two parts viz, fixed and variable.
  • The fixed element is based on the nature of the job (i.e., the rate for this part is fixed on the basis of job requirements).
  • Differential Time Rate: According to this method, different hourly rates are fixed for different levels of efficiency.
  • Payment by Results Piece Work Straight Piecework System: The wages of the worker depends upon his output and rate of each unit of output; it is in fact independent of the time taken by him.

• Exchange Rates

  • The price of one country's currency in units of another country's currency is known as a foreign currency exchange rate.
  • Exchange rates can be quoted in two ways: (1) A direct quote, is to state the number of domestic units of currency per one unit of foreign currency; (2) If an exchange rate is an indirect quote, the exchange rate is stated as the number of foreign units per one unit of domestic currency.
  • If a traveler has any foreign currency left over on his return home, he may want to sell it, which he may do at his local bank or money changer.
  • A market-based exchange rate will change whenever the values of either of the two component currencies change.
  • A speculator may buy a currency if the return (that is the interest rate) is high enough.

• Commercial Banks

  • Providing loans and other lending services, at established rates of interest
  • Risk management (i.e. foreign exchange risks, interest rates, hedging commodities, derivatives)
  • It is in measuring these risks that banks determine their interest rates and fees.
  • Credit Risk – Risk that a borrower may not return the entirety of the payment owed.
  • Operational Risk – Risk that an operational issue will diminish returns.

• Disadvantages of Corporations

  • In many countries, corporate profits are taxed at a corporate tax rate, and dividends paid to shareholders are taxed at a separate rate -- double taxation.
  • In many countries, corporate profits are taxed at a corporate tax rate, and dividends paid to shareholders are taxed at a separate rate.
  • The company profit being passed on is therefore effectively only taxed at the rate of tax paid by the eventual recipient of the dividend.
  • The shareholders must then report the income or loss on their own individual income tax returns.
  • The management of Leeman Brothers was involved in presenting a misleading picture of the company which collapsed in 2008.

• The Discount Rate

  • The Fed makes loans to depository institutions and charges different discount rates for each of discount windows.
  • The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates.
  • (Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve, at times, uses the term "discount rate" to mean the primary credit rate. ) The discount rate on secondary credit is above the rate on primary credit.
  • The discount rate for seasonal credit is an average of selected market rates.
  • Discount rates are established by each reserve bank's board of directors, subject to the review and determination of the Federal Reserve System's Board of Governors.

• Debt Finance

  • Lending to stable financial entities such as large companies or governments are often termed "risk free" or "low risk" and made at a so-called "risk-free interest rate".
  • A good example of such risk-free interest is a US Treasury security - it yields the minimum return available in economics, but investors have the comfort of the (almost) certain expectation that the US Treasury will not default on its debt.
  • A risk-free rate is also commonly used in setting floating interest rates, which are usually calculated as the risk-free interest rate plus a bonus to the creditor based on the creditworthiness of the debtor (in other words, the risk of him or her defaulting and the creditor losing the debt).
  • In reality, no lending is truly risk free, but borrowers at this rate are considered the least likely to default.
  • Companies also use debt in many ways to leverage the investment made in their assets, "leveraging" the return on their equity.