Financial Modeling Tutorials
- Financial Modeling Basics
- Excel Modeling
- Financial Functions in Excel
- Sensitivity Analysis in Excel
- Time Value of Money
- Future Value Formula
- Present Value Factor
- Perpetuity Formula
- Present Value vs Future Value
- Annuity vs Pension
- Present Value of an Annuity
- Doubling Time Formula
- Annuity Formula
- Annuity vs Perpetuity
- Annuity vs Lump Sum
- Internal Rate of Return (IRR)
- NPV vs XNPV
- NPV vs IRR
- NPV Formula
- PV vs NPV
- IRR vs ROI
- Break Even Point
- Payback Period & Discounted Payback Period
- Payback period Formula
- Discounted Payback Period Formula
- Profitability Index
- Cash Burn Rate
- Simple Interest
- Simple Interest vs Compound Interest
- Simple Interest Formula
- CAGR Formula (Compounded Annual Growth Rate)
- Effective Interest Rate
- Loan Amortization Schedule
- Mortgage Formula
- Loan Principal Amount
- Interest Rate Formula
- Rate of Return Formula
- Effective Annual Rate
- Effective Annual Rate Formula (EAR)
- Daily Compound Interest
- Monthly Compound Interest Formula
- Discount Rate vs Interest Rate
- Rule of 72
- Geometric Mean Return
- Real Rate of Return Formula
- Continuous compounding Formula
- Weighted average Formula
- Average Formula
- Average Rate of Return Formula
- Mean Formula
- Weighted Mean Formula
- Harmonic Mean Formula
- Median Formula in Statistics
- Range Formula
- Expected Value Formula
- Exponential Growth Formula
- Margin of Error Formula
- Decrease Percentage Formula
- Percent Error Formula
- Holding Period Return Formula
- Cost Benefit Analysis
- Cost Volume Profit Analysis
- Opportunity Cost Formula
- Mortgage APR vs Interest Rate
- Regression Formula
- Correlation Coefficient Formula
- Covariance Formula
- Coefficient of Variation Formula
- Sample Standard Deviation Formula
- Relative Standard Deviation Formula
- Volatility Formula
- Binomial Distribution Formula
- Quartile Formula
- P Value Formula
- Skewness Formula
- Regression vs ANOVA
Rate of Return Formula – Table of Contents
- What is Rate of Return Formula?
- Examples of Rate of Return Formula
- Relevance and Uses of Rate of Return Formula
What is Rate of Return Formula?
The rate of Return is the return that an investor expects from his investment. A person invests his money into a venture with some basic expectations of returns. The rate of return is basically calculated as a percentage with a numerator of average returns (or profits) on an instrument and denominator of the related investment on the same.
So, a Rate of Return Formula can be derived as below:
The rate of Return is a very dynamic concept for understanding investment returns; hence it can be modified and tweaked a little to calculate returns from various avenues.
- Average Return: Return measured after inputting all costs during the holding period, including admin charges, the premium paid (if any), other operating expenses, etc. All returns and costs should relate to only the asset in question, else it may deviate from accurate results.
- Initial Investment: Investment made initially to purchase the asset at the 0th period.
Examples of Rate of Return Formula (with Excel Template)
Let’s see some simple to advanced examples to understand the calculation of Rate of Return formula better.
Rate of Return Formula – Example #1
Anna owns a produce truck, invested $700 in purchasing the truck, some other initial admin related and insurance expenses of $1500 to get the business going, and has now a day to day expense of $500. Let’s consider hypothetically that, her everyday profit is $550 (ideally it will be based on sales). At the end of 6 months, Anna takes up her accounts and calculates her rate of return.
- Total Initial Investment: $2,200
- Everyday Expenses: $500
- Total Expenses for 6 months: $3,000
- Everyday Returns: $550
- Total Returns for 6 months: $3,300
So, we have the following data for the calculation of the Rate of Return Formula:
So, the calculation of the Rate of Return will be as follows –
Rate of Return Formula =((Total Returns -Total Expenses )/Total Initial Investment )* 100
Rate of Return = ($3,300 – $3,000) /$2,200 X 100
Hence, Rate of Return will be :
Accounting Rate of Return =13.64
Rate of Return Formula – Example #2
Joe has invested equally in 2 securities A & B. He wishes to determine which security will promise higher returns after 2 years. Likewise, he wants to decide whether he should hold the other security or liquidate such position.
Let us first find out returns from each security at the end of 1 year.
Return calculated for compounded interest is as below:
Below are the statistics related to his investment:
Interest Rate: 5% paid annually, compounded basis
Term to maturity: 10 years
A = PX [1 + R/n]^(nT)
- A = Amount (or Return) after a particular period of calculation
- P = Principal
- R = Rate of Interest
- n = Interest payment frequency
- T = Period of calculation
So, the calculation of Rate of Return for Security A(A1) will be as follows –
A = PX [1 + R/n]^(nT)
Therefore, Return after 2 years for Security A (A1) = $10,000 X [(1 + 0.05)^2]
So, Return after 2 years for Security A (A1) will be:
Return after 2 years for Security A(A1)=$11,025.
Interest Rate: 5% paid semi-annually, compounded basis
Term to maturity: 10 years
Therefore, calculation of Return after 2 years for Security B (A2) = $10,000 X [(1 + 0.05/2)^4]
So,Return after 2 years for Security B(A2)= $11,038.13
It is determined that although the returns are similar, yet Security B gives a little return. However, it is not required to completely liquidate the other position, as the difference between the two returns is minimal, as such Joe is not harmed by holding Security A.
Rate of Return Formula – Example #3
Joe wants to now calculate returns after the 10th year and wants to assess his investment.
Based on the returns calculated from the compound interest formula, we can calculate for 10 years as below:
So, the Calculation of Rate of Return for Security A(A1) for 10 years will be as follows –
A = PX [1 + R/n]^(nT)
Therefore,Calculation of Return for 10 years for Security A (A1) = $10,000 X [(1+ 0.05)^10]
So, Return for 10 years for Security A (A1) for 10 years will be:
Return for 10 years for Security A (A1)= $16,288.95.
Therefore,Return after 10 years for Security B (A2) = $10,000 X [(1 + 0.05/2)^20]
Return after 10 years for Security B(A2)= $16,386.16
Relevance and Use of Rate of Return Formula
The rate of return is the most critical calculation while investing in any asset:
- Every investor is exposed to risk and returns. The returns offered by an avenue may or may not be the actual returns over a period of time on the riskiness of the asset in markets. Hence it is extremely important to understand the actual rate of return for the investment.
- The rate of Return helps in capital budgeting decisions. It helps in identifying whether investing in a particular project is beneficial over a period of time and choose between options by comparing and identifying the best venture.
- It suggests the trends prevalent in the market and sometimes may even suggest futuristic views.
- A rate of Return is a simple calculation of suggestive investment for particular gains. One can make tweaks in their inputs and try to understand the amount to invest in order to earn particular returns.
- It is used to compare different investments and understand the background of such investment or benefits of the same.
- It gives the financial standing of the respective individual or firm as a whole.
The rate of return formula forms a pivotal terminology for all the analysis related to investments and their returns. It helps in various ways, as we have seen above, however only when calculated right. Although the rate of return equation seems like a simple formula, it gives results which are required for making some major decisions – be it in finances or other return related decisions. Hence, it is very important to arrive at the accurate calculation, as it forms the basis of entire investments, future planning, and other economic-related decisions.
This has been a guide to Rate of Return Formula. Here we discuss how to calculate the Rate of Return using its formula along with practical examples and downloadable excel templates. You may learn more about Financial Analysis from the following articles –
- Disadvantages of Compound Journal Entry
- Top 5 Best Examples of Capital Budgeting
- Calculate Monthly Compound Interest Formula
- Calculate Margin of Error Formula
- Calculate Percent Error Formula
- Calculate Holding Period Return
- Calculate Cash on Cash Return
- Calculate Real Rate of Return
- Calculate Geometric Mean Return