## Simple Rate of Return

The Simple Rate of Return, also known as the accounting rate of return (ARR) or return on investment (ROI), is a financial metric used to evaluate the profitability of an investment. It calculates the incremental profit expected from an investment as a percentage of the initial investment amount. It provides a straightforward perspective on the potential return of a project without considering the time value of money.

The formula for the simple rate of return is:

Simple Rate of Return = Incremental Annual Profit / Initial Investment

Where:

**Incremental Annual Profit**is the additional annual profit from the investment.**Initial Investment**is the upfront cost or investment amount.

Note: While the simple rate of return provides a basic understanding of an investment’s profitability, it does not consider the time value of money, risk factors, or the duration of the investment. For a more comprehensive view of an investment’s viability, other metrics such as the internal rate of return (IRR) or net present value (NPV) might be more appropriate.

## Example of Simple Rate of Return

Let’s dive into a practical example to illustrate the concept of the Simple Rate of Return.

**Scenario: Renovation of a Coffee Shop**

Jane owns a popular coffee shop in the city. She believes that renovating the shop and expanding the seating area can increase her annual profits due to a rise in customer capacity. After discussing it with her interior designer, she estimates that the renovation will cost $50,000.

After one year of operating post-renovation, Jane observes that her net annual profits, attributable to the renovation, have increased by $10,000.

Jane wants to calculate the simple rate of return on her renovation investment to evaluate its success.

Using the Simple Rate of Return formula:

Simple Rate of Return = Incremental Annual Profit / Initial Investment

Given:

**Incremental Annual profit**= $10,000 (The additional profit Jane earned due to the renovation.)**Initial Investment**= $50,000 (The cost of the renovation.)

Simple Rate of Return = $10,000 / $50,000

Simple Rate of Return = 0.20

Simple Rate of Return = 20%

Jane’s simple rate of return on the coffee shop renovation is 20%. This means that the renovation brought an additional return of 20% on her investment in the first year.

This example helps demonstrate how a business owner might use the simple rate of return to assess the effectiveness of a capital expenditure, like a renovation, in terms of its ability to generate additional profit.