Rate of Return on Capital Good.
One of the most important tasks of any economy, business, or household is to allocate its capital across different possible investments. Should a country devote its mvestrnent resources to heavy manufacturing like steel or to information technologies like the Internet? Should l-ucl build a S4 billion factory to produce the next generation of microprocessors? Should Farmer Jones: hoping to improve his record keeping, buy” customized accounting program or go with one of the popular varieties available for
around $100: All these questions involve costly investments- s-laving out money today to obtain a return in the future.
In deciding upon the best investment. we need a measure for that yield or return on capital. One important measure is the rate of return on capital, which denotes tlie net dollar return per year for every dollar of invested capital. Let’s consider the example of a rental car companr. Ugly Duckling Rental Company buys it used Ford for S10.000 and rents it out for S2500 per year. After calculating all expenses (maintenance, insurance, depreciation,” etc.), and ignoring any change in car prices, Duckling earns a net rental of S1200 each year. We say, then, that the rate of return on the Ford is 12 percent per year (= $1200 + SIO,OOO). Note also that the rate of return is a pure number per unit of time. That is, it has the dimensions of (dollars per period)j(dollars) and is usually calculated as percent per year.
You might be considering different investments: rental cars, oil wells, apartments, education, and so forth. Your financial advisers tell you that you do not have sufficient cash to invest in everything so how can you decide which investments to ‘make? One useful approach is to compare the rates of return 011 capital of the different investments. For each one. you first calculate the dollar cost of the , capital good. Then estimate the net annual dollar receipts or rentals yielded by the asset. The ‘ratio of the annual net rental to the dollar cost is the rate of return on capital: it tells you the amount of get back for every invested, measured a dollars per year per dollar of investment.
The rate of return on capital is the annual net return (rentals less expenses) per dollar of invested capital. It is a pure number-s-percent per year. Of Wine, Trees, and Drills. Her~ are some examples ‘ of rates of return on investments: “
• 1 buy grape juke for $10 and sell it a year later as wine for $11. If there are no other expenses, the rate of return on this investment i~ $1/$10, or 10 percent per year.
• I plant a pine tree with labor cost of $100. At the end of 25 years the grown tree sells for $4M. The rate of return oil this capital project is then 330 percent per quarter-century, which, a -calculator will show. is equivalent to a return of 6 percent per year. That is, $100 X (1.06)25 = 430.
• I buy a $20,000 piece of oil-drilling equipment.’ For 10 years it earns annual rentals of $30,000, but I incur annual expenses of $26,000 for fuel: ‘insurance, and maintenance. The $4000 net return covers interest and repays the principal of $20,000 over 1°years. What is the rate of return on ‘the drill? Statistical tables show that the ra te of return is 15 percent per year.
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