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Return on Investment (ROI) analysis is one of several commonly used approaches for evaluating the
financial consequences of business investments, decisions, or actions. ROI analysis compares
the magnitude and timing of investment gains directly with the magnitude and timing of investment costs.
A high ROI means that investment gains compare favorably to investment costs.
In the last few decades, ROI has become a central financial metric for asset purchase decisions
(computer systems, factory machines, or service vehicles, for example), approval and funding decisions
for projects and programs of all kinds (such as marketing programs, recruiting programs, and training
programs), and more traditional investment decisions (such as the management of stock portfolios or the
use of venture capital).
Simple ROI is the most frequently used form of ROI and the most easily understood. With simple ROI,
incremental gains from the investment are divided by investment costs.
Simple ROI works well when both the gains and the costs of an investment are easily known and where
they clearly result from the action. In complex business settings, however, it is not always easy to match
specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a
marketing program), and this makes ROI less trustworthy as a guide for decision support.
Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or
indirect costs, which are probably not caused directly by the action or the investment.
Year 1
100
20
30
40
70
80
140
100
70
60
40
30
20
120
Two aspects of the data are apparent at once: (1) Investment A has the greater overall net cash flow for
the five year period, but (2) the timing of cash flows in each case is quite different. The differences in
timing are even more apparent in a graphical representation of net cash flow:
To answer the question, "Which is the better business decision for the company?" the analyst will want to
examine both investments with several financial metrics, including ROI, NPV, IRR, and Payback period.
In order to calculate ROI, the analyst needs to see both cash inflows and outflows for each period (year)
as well as the net cash flow. The tables below show these figures for each investment, including also
cumulative cash flow and Simple ROI for the investment at the end of each year.
For Investment A...
Investment A
Cash Inflows A
Now
0
Year 1
40
Year 2
Year 3
50
Year 4
Year 5
95
105
75
Total
355
Cash Outflows A
100
20
20
35
25
25
225
100
20
30
40
70
80
140
Cumulative CF A
100
80
50
10
60
140
Simple ROI A
-100.0%
66.7%
35.7%
5.7%
30.0%
62.2
%
Now
Year 1
Year 2
Year 3
Year 4
Year 5
Total
100
90
75
50
40
355
Cash Outflows B
100
30
30
35
20
20
235
100
70
60
40
30
20
120
Cumulative CF B
100
30
30
70
100
120
Simple ROI B
-100.0%
23.1%
18.8
%
35.9%
46.5%
51.1
%
Simple ROI for each investment, in each period is shown in the bottom row of each table. Applying the
cash flow ROI formula above to these data, the ROI for, say, Year 3 of Investment B is given as
Using simple ROI as the sole decision criterion, which investment is the better business decision? The
answer here is: that depends on the time period in view.
Considering the 3-year ROIs from each investment, clearly B's ROI of 35.9% is better than
A's ROI of 5.7%.
Considering the 5-year ROIs however, investment A clearly has the higher ROI at 62.2%, vs.
51.1% for B's five-year ROI.
The example illustrates two important considerations to keep in mind when using ROI for decision
support:
1. For most business investments there is not a single ROI for the investment, independent of the
time period. Because business investments typically bring financial consequences extending
several years or more, the investment can have a different ROI every year (or other period). The
investment's ROI is not defined, that is, until the time period is stated.
2. The standard advice usually repeated when ROI is explained (as above) is: this: "Other things
being equal, the investment with the higher ROI is the better business decision." However,
important business decisions are rarely made on the basis of one financial metric and with
business investments, moreover, the condition "other things being equal" almost never applies.
When comparing investments with ROI, it is usually a very good idea to consider other financial
metrics as well (as illustrated in the following section).
As a final consideration in calculating ROI, note that some financial specialists prefer to derive ROI from
cash flow stream present values. In investment situations, this typically leads to a lower ROI than the ROI
from the non discounted cash flow. That is because the larger investment costs usually come early, and
the larger gains appear later, so that discounting impacts the future gains more heavily than the future
costs. In the "early costs / later gains" situation, using discounted cash flow figures to calculate ROI leads
to a more conservative, less optimistic result. There are "pros" and "cons" to both the discounted and non
discounted approach to ROI, and the business analyst should be sure to understand which approach is
preferred by the organization's financial officers, and why.
Which investment, A or B, is the better business decision? In this section, you should see that each
investment has points in its favor, compared to the other, and that ultimately decision makers will have to
weigh ROI results along with several other metrics, to decide which is best for their organization at the
present time. Here are some of the points to consider:
ROI: Investment A has the higher 5-year ROI (62.2% for A vs. 51.1% for B). That is a point in A's
favorif the time period in view is 5 years.
Future Performance: The cumulative curves above only cover 5 years, but if the investments
inflows and outflows are expected to continue beyond 5 years, the curves point to two different
futures. By Year 5, A's cumulative cash flow curve is heading skyward, while B's appears to be leveling
off. If there is reason to believe these patterns will continue, this is also a point in favor of A.
Payback Period. The cumulative cash flow curves above show roughly the point in time when
the cumulative cash flow "breaks even," that is, when cumulative incoming returns exactly balance
cumulative outflows. This point in time (point on the horizontal axis) is Payback period for each
investment (see payback period). The payback period for B is 1.5 years, while A's payback period is
3.14 years. Investment B "pays for itself" in half the time of investment A. The shorter payback period
is preferred because it means invested funds are recovered sooner, and available for use again sooner.
The shorter payback period is also viewed as less risky than the longer payback. These are points in
favor of investment B.
Net present value (NPV): Using a 10% Discount rate, Investment B has a net present value
(NPV) of 76.18, while A's NPV is 70.51. With the time value of money rationale, this means that
investment B is worth more, today, than investment A, even though A will ultimately (in 5 years) return
more funds. This is a point in favor of B.
Internal rate of return (IRR): Internal rate of return (IRR) is the interest rate that produces an
NPV of 0 for a cash flow stream (see Internal rate of return for a complete overview of what this means
and why it can be important). Investment A has an IRR of 28.9% while B's IRR is 44.9%. Roughly
speaking, financial officers will view a potential investment with an IRR above their cost of borrowing as
a net gain. When investments are competing for funds, of course, the higher IRR is preferred. This is a
point in favor of investment B.
Based on the financial metrics reviewed above, which investment, A or B, is the better business decision?
Clearly there is no "one size fits all" answer, except to say that ROI is one factor decision makers and
planners will consider, but they will consider other factors as well and give different "weights" to the
different financial metrics above, based on (a) the company's business objectives, and (b) the current
situation.
Understands the limits of the concept when used to support business decisions