Return on Investment and the Implications of Leverage

    

Growth in purchasing power of every dollar that you hold is indispensable to your wealth-building. The growth of investment assets, over and above the growth necessary to offset the negative effects of inflation and income taxes, is the key to wealth enhancement. That said, it is essential that you optimize your investment capital (dollars set aside for investment); however, you cannot optimize your capital allocation, unless you comprehend return on investment.

Calculating Return on Investment (ROI)

Return on investment (ROI) is a universal metric that provides you with quick answers when choosing among alternative investment opportunities. ROI is effectively the profit that you realize upon the sale of your investment; and that profit is stated as a percentage of the amount of money that you initially used to obtain the investment asset. If you realize a 100 percent investment return, then you effectively doubled the money that you originally used to make the investment.

To determine ROI, the mechanics of the calculation call for you to sell the asset and receive proceeds, subtract the cost of acquiring it, and then divide that difference again by the cost of acquiring the asset (proceeds minus cost, then divide the difference by cost).

ROI = P - C ÷ C

Where:

P = proceeds received upon sale

C = cost of acquiring the asset

ROI = $12,500 - $10,000 ÷ $10,000

ROI = $2,500 ÷ $10,000

ROI = .25 (25%)

By example, if you sold shares in Nanotech, Inc. and received $12,500 in proceeds, subtract your cost of acquiring the shares, (illustratively $10,000) from proceeds received, and then divide that $2,500 difference by the total cost of acquiring the asset… $10,000 in this scenario. In this case you divide $2,500 by $10,000 and you get .25, or a 25% ROI.

Using the 25% ROI metric, you can compare this result against returns on certificates of deposit, savings bonds, corporate bonds, etc.

Financial Leverage affects ROI

If you borrow money to purchase an investment asset, then you may receive a very large amount of total profit, in money terms, even though the ROI appears the same for two competing investments. Financial leverage allows you to control an asset that is much more valuable than you might otherwise be able to buy without the use of that leverage.

Imagine two investors: they both have $10,000. One will purchase Nano-tech stock and the other will purchase an investment property. The first investor uses his $10,000 and, per the example above, will realize a 25% ROI. However, the second investor used his $10,000 to make a 10% down-payment on an investment property and borrowed $90,000 from a mortgage bank. The second investor will buy a $100,000 asset (an income-producing investment property) with only 10% of that cost coming from his own pocket. Because of using so little of his own money, and borrowing the rest, this investor is considered "highly leveraged".  Both investors will realize a 25% ROI. Mr Nano-tech will sell his asset for $12,500, while our leveraged property investor will sell his asset for $125,000. The property investor must pay off the bank loan of $90,000, before walking away with the remaining $35,000 balance (there are closing costs that might reduce this to $32,500). After both investors recoup their original $10,000 investment, then Mr Nano-tech gets $2,500 profit and Mr Property gets approximately $22,500 in profit.

You should have noticed something rather odd happening by now. Both investors saw their respective assets appreciate by 25 percent. However, the leveraged investor received $22,500 in pre-tax profit, whereas the un-leveraged investor received a mere fraction of this amount, $2,500, in pre-tax profit.

Returning to ROI, both investors received a 25% ROI. You should see that ROI does not always tell you the whole story. The ROI calculation does not consider the question of whether an asset is purchased with cash or with borrowed money. Here the property investor received almost 10 times as much total money (as pre-tax profit) as the stock investor . . . because of the effects of financial leverage.

One note of caution is important: financial leverage cuts both ways. It can greatly increase one’s total profit on an investment, but it can also financially destroy the person who is not well-prepared to weather a financial storm. Ignore all promoters, advertisers, and other slick-talkers who insist that, despite having poor credit and/or no money, that you can get rich with "no money down" investments. Where financial leverage is employed (borrowing to purchase an investment), it is critical that you have sufficient resources to pay the lender (and other costs) for an extended period if the investment does not go as planned. In short, financial leverage can help you greatly with the right planning; but it can also be a deadly killer when not managed properly.

 

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