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Financial Accounting: Help and Review18 chapters | 235 lessons

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Lesson Transcript

Instructor:
*Jarvista Rivers*

In this lesson, we will define the rate of return and explore how it's used in today's business decisions. Using the formula and an example, we'll learn how to calculate the rate of return to determine if a particular business decision is a wise one.

The **rate of return** is the amount you receive after the cost of an initial investment, calculated in the form of a percentage. The percentage can be reflected as a positive, which is considered a gain or profit. When the percentage is negative, it reflects a loss. This information is very useful in determining whether or not the initial investment you made was a good one.

There are many reasons why it would be advantageous to know the rate of return on your investment. After all, how would you know if your investment was a wise choice? Calculating the rate of return provides important information that can be used for future investments. For example, if you invested in a stock that showed a substantial gain after several months of performance, you may decide to purchase more of that stock. If the stock showed a continual loss, it may be wise to conduct research to find a better-performing stock.

Another advantage of calculating the rate of return is that it allows you to gauge your investment and decision-making skills. Investments that create a gain or profit are great. However, if you continually make investments at a loss, then you may want to change your investment strategies. A great attribute of successful business people is knowing how and when to make investments, as is knowing when to change strategies. With a firm grasp of calculating the rate of return, you can manage and monitor your investments at various stages to determine the outcome of your investments. This leads to a higher level of confidence and the skills necessary to be a savvy investor.

The **rate of return formula** is an easy-to-use tool. There are two major numbers needed to calculate the rate of return:

**Current value**: the current value of the item.

**Original value**: the price at which you purchased the item.

Then, apply these values to the **rate of return formula**:

((Current value - original value) / original value) x 100 = rate of return

Remember, the outcome is always reflected as a percentage, so the formula requires you to multiply by 100 to get the percentage. If this percentage is a positive number, then you have a profit or gain on your investment. If the percentage is a negative number, then you have a loss on the investment.

Let's say that in 2002 you purchased a home for $200,000. In the next few years, homes in your neighborhood have been selling well due to the new shopping plaza a couple of miles away, which increased the market value of your home. So in 2007, you decided to downsize and sell your home. Based on the current market value during this time, you were able to sell your home for $250,000. Using the formula, let's calculate the rate of return on your investment:

Current value = 250,000

Original value = 200,000

Plugging these variables into our formula, we get: ((250,000 - 200,000) / 200,000) x 100.

250,000 - 200,000 = 50,000

50,000 / 200,000 = .25

.25 x 100 = 25%

In this example, you made a 25% return or profit from your initial investment of $200,000.

What if you waited until 2008 to sell your home? This could have easily changed the rate of return due to the market decline and housing bubble of 2008. Let's apply the 2008 current value to the formula:

Current value = 175,000

Original value = 200,000

Plugging these variables into our formula, we get: ((175,000 - 200,000) / 200,000) x 100.

175,000 - 200,000 = -25,000

-25,000 / 200,000 = -.125

-.125 x 100 = -12.5%

In this second example, you made a loss on your investment. This also demonstrates that timing can be an important factor in the rate of return.

Let's review. The **rate of return** is the amount you receive after the cost of an initial investment, calculated in the form of a percentage. Using the **rate of return formula** is a great way to determine if you have made a profit or a loss on your investment.

The main ingredients for calculating the rate of return are the **current** and **original** values. The final outcome is always reflected as a percentage. The advantages to using this tool are to understand the performance of your investment and to assist in future investments and strategies. It can also help you develop the skills and confidence necessary to become a savvy investor.

**Rate of return** - the amount you receive after the cost of an initial investment, calculated in the form of a percentage

**Rate of return formula** - ((Current value - original value) / original value) x 100 = rate of return

**Current value** - the current price of the item

**Original value** - the price you originally paid for the item

After watching this video, you should be able to:

- Define rate of return
- Explain why knowing the rate of return is beneficial
- Use the rate of return formula to compare current and original values of an investment

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30 in chapter 5 of the course:

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Financial Accounting: Help and Review18 chapters | 235 lessons

- The Differences Between Accrual & Cash-Basis Accounting 6:20
- Using Accrual Accounting to Make Financial Statements More Useful 5:47
- Accrued Expenses & Revenues: Definition & Examples 4:30
- Preparing Financial Statements 7:35
- Temporary & Permanent Accounts: Definition & Differences 4:57
- Real Accounts vs. Nominal Accounts: Definition, Differences & Examples 4:55
- Debt Financing: Definition, Types, Advantages & Disadvantages
- Deficit Financing: Definition & Concept
- Differential Cost in Accounting: Definition, Analysis & Formula 5:21
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- How to Calculate Asset Turnover Ratio: Formula & Example 5:24
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- How to Calculate Net Present Value: Definition, Formula & Analysis 6:04
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- How to Calculate Net Working Capital: Definition & Formula 5:06
- How to Calculate Owner's Equity: Definition, Formula & Examples 4:09
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- How to Calculate the Rate of Return: Definition, Formula & Example 5:04
- How to Calculate Yield to Maturity: Definition, Equation & Example 5:14
- Unearned Revenue in Accounting: Definition & Examples 4:46
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