When promoting the benefits of investing in energy-saving products, one of the most popular metrics is Return on Investment (ROI). Among these, the payback period is frequently used to assess energy-saving projects. But for those who aren’t accountants, what does ROI actually mean, and how do they calculate it?
Before calculating ROI, a business often begins by setting a hurdle rate, or the minimum acceptable rate of return for a project. Next is determining the Rate of Return (RoR) for the investment and comparing it to the hurdle rate. If the RoR surpasses this benchmark, the investment is considered viable. If not, the project may not be worth pursuing.
Hurdle Rate
A hurdle rate is the minimum rate of return that a company expects to earn when investing in a project. Think of it as a benchmark. If an investment does not promise returns above this rate, it is not worth pursuing. It is like setting a bar that any investment opportunity needs to jump over to be good enough. It considers factors like risk and the cost of capital. Moreover, higher risk projects typically have higher hurdle rates.
Rate of Return (RoR)
Stakeholders are interested in a rate of return, this is the gain or loss on an investment over a specified period, expressed as a percentage of the investment’s initial cost. It tells you how much you earned or lost compared to the amount you put in. In other words, it is a way to gauge the profitability and efficiency of an investment, helping to compare different opportunities. It is like ROI but more flexible in its application across distinct types of investments and time frames.
Companies can use distinct methods for evaluating investments. These methods give different perspectives on whether an investment is worth pursuing, providing more depth than just RoR or ROI. Each one tells them something slightly different about an investment’s potential. They are:
Payback Period
This is simply how long it takes to get your initial investment back. If you invested £100 in a project and it returns £25 a year, the payback period would be £100 divided by £25 or four years. Likewise, for an energy saving project costing £100 that saved £25 a year.
Simple return on investment
Imagine you bought a bike for £100, and later you sold it for £150. Your ROI is the profit you made (£50) divided by the original cost (£100), then multiplied by one hundred, so 50%.
Annualised Return on Investment
This tells you the average annual return of an investment. If you held the bike for 2 years, it would adjust the ROI to show what the yearly return was. It smooths out the return over the investment period.
Net Present Value (NPV)
Think of this like valuing future cash flows in today’s money. If someone offered you £10 a year for the next 10 years, NPV helps you figure out what that future cash is worth today, considering factors like inflation or interest rates.
Internal Rate of Return (IRR): This is the interest rate at which the NPV of all cash flows (both in and out) equals zero. It is like finding the magic number that balances your investment’s costs and returns over time.
We hope this introduction clarifies the fundamentals of Return on Investment. For more tailored guidance, consult your accountant.