Simple Rate of Return Method in Capital Budgeting

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  • 0:03 Simple Rate of Return Method
  • 0:49 How Is it Calculated?
  • 1:17 Using It in Planning
  • 1:43 Disadvantages
  • 2:16 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Companies need quick ways to analyze whether or not a potential capital expense is worth their time. That's just what the simple rate of return method provides. In this lesson, we learn how it is calculated and how it is used.

Simple Rate of Return Method

Companies are always looking at ways to expand their operations to make sure that they are as profitable as possible. This means constantly analyzing new possibilities for capital investments, which are investments that, despite not being turned into something that is produced by the company, are useful for increasing profits.

As you might expect, there are plenty of plans that are put forward to help a company make more money. How is a decision-maker supposed to sort through them all? Luckily, there is a solution. The simple rate of return method allows companies to quickly calculate a simple rate of return. A simple rate of return is how much a company expects to make off of a capital investment every year. Using this figure, a company can quickly see if a plan is worth its time and money.

How Is it Calculated?

Calculating the simple rate of return is just as straightforward as you'd imagine. Simply divide the expected yearly profit of the upgrade by the total cost of the upgrade. By doing so, you'll end up with a decimal that you convert to a percentage. This percentage is the simple rate of return. However, without guidance it is relatively useless. A company has to have a well-developed plan in place in order to make use of the simple rate of return.

Using It in Planning

A simple rate of return is just a number unless a company has some idea how to use it. Again, depending on the company, the guidelines for using the rate could be very different. Some companies allow their managers to spend up to a certain point on a plan that has received a favorable simple rate of return. For other companies, it is merely a starting point for a more involved examination of the suggested upgrade or purchase.

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