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Return on Investment (ROI)

See Also:
Return on Invested Capital (ROIC)
Return on Common Equity
Internal Rate of Return Method

Return on Investment (ROI) Definition

Return on investment (ROI) is the ratio of profit made in a financial year as a percentage of an investment. In other words, ROI reveals the overall benefit (return) of an investment using the gain or loss from the investment along with the cost of the investment.

Return on Investment Explanation

Return on investment is a useful and simple measure of how effective a company generates profits from an investment. Many firms use ROI as a convenient tool to compare the benefit of an investment with the cost of the investment. For example, if a company effectively utilizes an investment and produces gains, ROI will both be high. Whereas if a company ineffectively utilizes an investment and produces losses, ROI will be low. For investors, choosing a company with a good return on investment is important because a high ROI means that the firm is successful at using the investment to generate high returns. Investors will typically avoid an investment with a negative ROI, or if there are other investment opportunities with a positive ROI. Return on investment models are used often because the ROI ratio and inputs can be modified to fit different companies and financial situations.

Similar formulas to calculate profitability include return on equity, return on assets, and return on capital.

How to Find Return on Investment

The return on investment ratio calculates the percentage return (profitability) on an investment. Check out the following ROI formula:

Simple Return on Investment Ratio = (Earnings from Investment – Cost of Investment) ÷ Cost of Investment

One issue with the simple return on investment formula is that it is often used for short-term investments, so it does not account for the time value of money. Thus, it is less accurate for calculating ROI for long-term investments over one year. To measure the long term return on investment for future years, use the discounted ROI formula.

Discounted Return on Investment Ratio = Net present value of benefits ÷ Total present value of costs

= (PV Earnings from Investment – PV Cost of Investment ) ÷ PV Cost of Investment

Return on Investment Example

For example, this year, ABC company has produced earnings of $50,000 from an investment. The cost of the investment was $30,000.

Simple Return on Investment Ratio = ($50,000 – $30,000) ÷ $30,000 = 67%

Based on the result, we assume that ABC company has an annual percentage return on investment of 67%. The benefit (gain) was $50,000 and the investment cost was $30,000.

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Hiring an Investment Banker?

investment bankerSince the economic recession that started in 2007, many people have perceived investment bankers negatively. The recession was caused in great part by the careless and unwise actions of investment banks and their regulators. Despite the negative impression people have of investment bankers, they are extremely beneficial for the economy and for individuals and companies to be profitable.

Hiring an Investment Banker?

Many larger firms use an in-house team for handling the issuance and trading of securities. However, there may be a point in the growth stage of your business that you need the external financial services of an investment banker. While there is a cost to investment banking, there are proven benefits of having outside intelligence oversee your company’s finances and securities. Following are the areas where investment bankers can help you:

Access to Capital:

Investment bankers have extensive relationships with investors, who have readily-available capital to invest in your business. Access to the investment bankers’ network of investors is a significant advantage when raising capital to invest in new technology, make strategic purchases or expand business operations. In addition, investment banks provide you with the resources and expertise you need to structure and implement deals to raise capital at profitable price points.

Knowledge about Partnerships, Mergers and Acquisitions: 

Business intelligence is the key to strategic decision-making. Investment bankers usually have extensive industry knowledge that can help you discover new opportunities to expand your business. These strategic opportunities include partnerships, mergers, and acquisitions.

Consultative Services:

Investment bankers make transactions happen for you in the moment. They also use their industry expertise and experience to advise and prepare you to act when advantageous opportunities present themselves in the future.

Working with investment bankers can be the key to your success. The ability of investment bankers to raise capital not only drives your business forward, but also the economy forward. For small businesses without financial investment divisions, hiring an investment banker will allow you to better manage investment decisions. An investment bank can put you in the best position to take advantage of strategic investment opportunities.

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Determine which candidates are the right fit for your company using our 5 Guiding Principles For Recruiting a Star-Quality Team.

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What is Investment Banking?

See also:
What Your Banker Wants You To Know
Alternative Forms of Banking
Debt Compliance 101: Keep Your Banker Happy
Manage Your Banking Relationship

What is Investment Banking?

What is investment banking? Investment Banking is an elite financial service to advise companies, individuals, and governments on financial and investment decisions. They also help them raise equity and debt capital. Investment banks help companies develop their investment portfolios and expand access capital markets. Capital markets include the stock and bond markets. Investment bankers are known to be the well-trained and effective contributors in the financial market. Because large firms raise significant capital through selling securities, they usually use the services of an in-house security issuance division or an investment banking institution. These banks often offer cost savings compared to maintaining an in house security issuance division.


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Investment Bank Analysts

Investment banking analysts serve as consultants for companies during mergers, acquisitions, and reorganizations of companies. Consultative services within an investment bank provide guidance and advice about the issue and placement of securities as well as the management of public assets. Furthermore, these analysts evaluate financial markets to guide companies on when to make public offerings.

Investment Bankers as Executors

Investment bankers are able to execute purchases and transactions for their clients. They act as their clients’ agents when purchasing, selling, or trading securities. If a company is in need of buyers for their stocks or bonds, then an investment bank finds those buyers and handles the transaction with appropriate attorneys and accountants.

Raising Capital

Investment bankers raise debt and equity capital for their clients. Raising debt capital includes issuing bonds to generate funds. Raising equity capital includes launching a company’s initial public offering (IPO).

The Buy Side

Investment bankers working on the “buy side” usually handle buying investment services, including the following:

The Sell Side

Investment bankers working on the “sell side” usually handle the trading. In addition, they sell investment services, such as facilitating security transactions, engaging in market making, and selling IPOs.

Examples of Investment Banking Firms

Some examples of investment banking firms include the following:

  1. Goldman Sachs
  2. Morgan Stanley
  3. JP Morgan Chase

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3 Myths about Private Equity Investors

traditional financingMyths about private equity can inhibit entrepreneurs from pursuing business opportunities and making rational decisions.  Private equity financing is a complex decision for business owners.  These owners should analyze other financing options and goals for future growth of the company before making important investment decisions.

Here are three myths about private equity investors

1.  Private equity investors take advantage of business owners.

Private equity is not intended to be a win for the investor and a loss for the business owner. The investor’s best interest is that the entrepreneur grows the business and increases its value so that BOTH sides win.  Private equity investors are not profitable if the value of the company depreciates.

Many business owners perceive private equity investors as greedy and manipulative in cutting them out of the success of their companies.  However, most of the time these perceptions arise when entrepreneurs:

  • Lose control
  • Blame private equity investors for the demise of their companies

As long as you leave at least half of the company in your ownership, as an entrepreneur, you will have control over your company to make important strategic decisions. Most private equity investors don’t want to run your company or take advantage of you. Instead, they just want to contribute to your business’s success. 

2.  Private equity investors do not add value beyond their monetary investments.

While many people view private equity investors solely as sources of capital, this misconception is untrue. Most investors have expertise and experience in the various industries. Many experience come from past investments in successful companies and others from being entrepreneurs and chief officers themselves.  They have the know-how to advise businesses from an impartial outlook and to add value by bringing in fresh ideas and perspectives.

Investors also have a network of connections to help companies advance and develop strategic partnerships. An investor with a good understanding of the company that he or she invests in will do more than just invest money into a business. They will help grow the company’s value in a rational and sustainable approach.

3.  Once a private equity investor is ready to exit his or her investment, the business owner has to sell the company or take it public.

Business owners are not forced to sell their companies or take them public once a private equity investor decides to exit.  Private equity firms usually invest in companies with a goal of exiting within five to eight years. The private equity firm’s partners expect liquidity at a certain point in time. As a result, the firm cannot hold on to all investments forever. At this point, the business owner has several choices, including raising capital from a new private equity investor or a new partner

Avoiding these common misconceptions will allow you to focus on the positive benefits. Therefore, you can make better decisions about private equity investments.

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Return on Invested Capital (ROIC)

See Also:
Return on Equity Analysis
Required Rate of Return
Return on Asset Analysis
Financial Ratios
Weighted Average Cost of Capital (WACC)
Return on Capital Employed (ROCE)

Return on Invested Capital (ROIC) Definition

The return on invested capital (ROIC) is the percentage amount that a company is making for every percentage point over the Cost of Capital|Weighted Average Cost of Capital (WACC). More specifically, the return on investment capital is the percentage return that a company makes over its invested capital. However, the invested capital is measured by the monetary value needed, instead of the assets that were bought. Therefore invested capital is the amount of long-term debt plus the amount of common and preferred shares.

Return on Invested Capital (ROIC) Formula

The return on invested capital formula is as follows:

Net Operating Profit After Tax (NOPAT)/Invested Capital = ROIC

NOPAT – This is the operating profit in the income statement minus taxes. It should be noted that the interest expense has not been taken out of this equation.

Invested Capital – This is the total amount of long term debt plus the total amount of equity, whether it is from common or preferred. The last part of invested capital is to subtract the amount of cash that the company has on hand.


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Return on Invested Capital (ROIC) Example

For example, Bob is in charge of Rolly Polly Inc., a company that specializes in heavy agricultural and construction equipment. Bob has been curious as to how his company has been performing as of late and decides to look at the company’s return on invested capital analysis. Surprisingly, the company does not keep track of the return on invested capital ratio. Bob decides that he will go ahead and run the ROIC analysis, and obtains the following information:

Long-term debt – $25 million
Shareholder’s Equity – $75 million
Operating Profit – $20 million
Tax Rate – 35%
WACC – 11%

Plugging these numbers into the formula Bob finds the following:

$20 million – (20 million * 35%) = $13 million

$13 million/($25 milion + $75 million) = .13 or 13% = ROIC

To see how well the company is actually generating a return, Bob then compares the 13% to the WACC which is 11%. Thus, Bob find that the company is generating 2% more in profits than it cost to keep operations going.

As a financial leader, it is your role to improve the bottom line and calculate the return on invested capital. Managing a high return is more attractive to potential buyers. If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

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What is Compound Interest?

See Also:
Effective Rate of Interest Calculation
When is Interest Rate Not as Important in Selecting a Loan?
Interest Expense
Nominal Interest Rate
Interest Rate Swaps

What is Compound Interest?

Compound interest is interest earned on the principal plus interest earned on prior interest. Compounding interest rates not only earn interest on the original money, but also on the interest itself. The interest earns interest. Or, as Benjamin Franklin put it, “The money that money makes, makes money.”

For example, if an investor invests $100 at a 10% interest rate compounded yearly, during the first year the investment would earn interest on the original $100, and the next year the investment would earn interest on the original $100 plus the $10 of interest earned in the prior year.


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Compounding Periods

You can compound compound interest at different intervals, such as yearly, semi-annually, quarterly, monthly, daily, or continuously.

For yearly compounding interest rates, the original capital earns interest at the stated annual rate over the course of the year. The following year, the interest earned during the first year is added to the original capital, and the investment earns interest on the new amount.

For semi-annual, quarterly, monthly, or daily compounding interest rates, the original capital earns interest for the stated time period. At the end of that stated time period, the interest earned is added to the capital, and for the next period interest is earned on that new amount. This continues and the amount of money that earns interest gets larger and larger each period.

For a continuously compounding rate, the compounding period is an instant. In this case, compound the interest an infinite number of times during the course of a year.

Compound Interest and Simple Interest

There is a difference between compound interest and simple interest. An investment with compound interest grows faster than an investment with simple interest. Simple interest is interest earned on the original amount of capital. Each time period, the stated interest rate applies only to the principal amount. With simple interest, the interest itself does not earn interest.

For example, if $100 is invested at 10% yearly simple interest rate, then the investment earns $10 of interest each year. Each year, the interest rate applies only to the original $100 dollars and not to the accumulating interest.

Compound interest, as stated above, earns interest on the principal as well as the interest earned in prior periods. For example, if an investor invests $100 at a 10% interest rate compounded yearly, during the first year the investment would earn interest on the original $100, and the next year the investment would earn interest on the original $100 plus the $10 of interest earned in the prior year.

Compound Interest Formula

Here is how you calculate the value of an investment with compound interest after a certain number of years. First, divide the annual interest rate by the number of compounding periods. Then add one to that number. Next raise that value to the product of the number of compounding periods multiplied by the number of years of the investment. Take the value, and multiply it by the principal value. This gives you the ending value of the investment including compounded interest.

Investment Value = Principal x (1 + (Annual Rate/Periods))periods x years

Compound Interest Monthly Formula

Use the following formula to calculate compound interest on a monthly basis:

Investment Value = Principal x (1 + (Annual Rate/12))12

For example, if you invest $100 at an annual rate of 6% that compounds monthly, then at the end of one year, the value of the investment would be $106.17.

$106.17 = $100 x (1 + (.06/12))12

Compound Interest Formula Quarterly

Use the following formula to calculate compound interest on a quarterly basis:

Investment Value = Principal x (1 + (Annual Rate/4))4

For example, if you invest $100 at an annual rate of 6% that compounds quarterly, then at the end of one year, the value of the investment would be $106.14.

$106.14 = $100 x (1 + (.06/4))4

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What is a Term Sheet?

What is a term sheet? It contains the terms of an investment made by a venture capital firm. It is a summary of the legal and financial terms of a proposed deal. Basically it is a letter of intent (LOI) for venture capital investments.

Term Sheet & Valuations

It is important to understand the pre and post money valuations of your firm if you are taking on a VC partner. Contain the details of these valuations within the term sheet. It is important to understand how much of the equity you will hold after the transaction. Each round of equity financing typically has its own terms.

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See Also:

Other Peoples Money
Angel Investor
Venture Capital
5 Cs of Credit
Working Capital

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