Rate of Return-Another Good Profitability Measure

RATE OF RETURN-ANOTHER GOOD PROFITABILITY MEASURE 

After the net present value has been determined, what does it mean Is 800,000 a good, average, or poor value If the net present value is positive we know the plant is making more profit than if the capital were invested at the interest rate used. But how much higher—1%—2%—10% The only way of knowing is to determine the interest rate that gives a net present value of zero. This interest rate is known as the rate of return. Some companies use the rate of return to determine the optimum investment. The project with the largest return is considered the best. This is also known as the yield on investment method. 

Where the calculation of the net present value was straightforward, die determination of the rate of return requires a trial-and-error procedure. An interest rate is chosen and then the net present value is determined. If it is not zero, another interest rate is chosen and the net present value is recalculated. This is continued until a zero net present value is obtained. 

Calculate the expected rate of return for a plant that has a present value of — 18,000,000 at startup. The proceeds are expected to be  

Raising the interest rate 5% decreases the net present value 3,200,000. If this were extrapolated to get NPV = 0, i should be around 17% (this is a very rough guide). 

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