When a person invests his own money in an object that generates income, he expects not only to make a profit from the invested capital, but also to fully compensate him. This can be done through resale or by obtaining such profits that not only bring interest, but also gradually return the investment.
Introductory information
When an investor invests his own capital in a certain object, he expects that he will receive a refund and profit. There are three popular ways to calculate estimated time values:
- The method of rectilinear return of capital. Named after Ring.
- The method of returning capital at the rate of return on investment and the recovery fund. Named after Inwood.
- The method of returning capital at a risk-free interest rate and reimbursement fund. Named after Hoskold.
Summary
Let’s literally describe in a couple of words what each of them is:
- Ring Method. It involves the development of a scenario according to this procedure: the reimbursement of the main amount of invested capital is carried out in equal parts. In this case, the size of payments will not differ. This method assumes that there will be an annual decrease in the value of the cash flow that is used to pay off the debt. Therefore, it cannot be used in cases where the income is uneven.
- Inwood Method. The rate of return on investment is equal to the recovery fund factor, which is calculated at the same interest rate as in the case of investment income. Using this approach is advisable with a full return on investment and obtaining from them the corresponding profits.
- Hoskold's method. It is used in cases where it is likely that part of the invested capital will be lost during the transaction. In this case, current income is considered both as a reimbursement and as a profit from an investment. For example, this is relevant for the demolition of a residential building, which was leased. Therefore, the return on investment according to the Hoskold method should be built on the basis of not only returning the invested capital, but also making a profit from the manipulations performed.
Now let's look at them in more detail.
Ring Method
Now let's look more at the mathematical aspects. To get the annual rate of return on capital, you must divide 100% of the value of the asset by its remaining useful life. In other words, you need the reciprocal of the life of the asset. The rate of return is the annual share of the initial capital that is placed in the interest-free compensation fund.
Consider a small investment example. Let's say there is an investment of five years. The rate of return is 18% per annum. In this case, the annual straight-line rate of return on capital will be 20%. This is achieved by simple manipulations: 100% / 5 = 20%. The capitalization ratio in this case will be 38%. For those who do not understand where this number came from: 18% + 20% = 38%.
Inwood Method
This approach is used in cases where a decision has been made to reinvest the returned capital at the rate of return on the investment. Another name for this option is the annuity method. Here is a small example: the investment period is five years. Return on investment is 12%. The compensation fund factor (from its reinvestment) is 0.1574097%. Thus, the coefficient will be equal to 0.2774097%.
Hoskold Method
The formula of this approach is applied when the rate for the initial investment is not high. And it is highly unlikely that re-investment on it looks like. Therefore, as a support in mathematical calculation, the use of a risk-free rate is assumed.
To understand, let's look at a small example. There is an investment project that offers a return of 12% per annum on investments for a period of five years. Certain amounts due to the return of funds can be re-invested without risk at a rate of 6%. The rate of return of capital with this factor of compensation is 0.1773964. The coefficient in this case will be equal to 0.2973964.
But what does the formula look like? The Hoskold method involves the use of a slightly more complex expression. In general terms, it looks as follows: R cap. = R doh. Cap + Δ · R norm. return
The greatest interest in the calculations is Δ. After all, it depends on this symbol whether this value is beneficial or not. So, Δ will be equal to zero if the value of the valuation object does not change. A positive value can only be with a decrease in its price. It displays the fraction that will fall. The minus value is set if it is planned to increase the value of the object. It also displays the share by which approximately growth will occur. The rate of return according to the Hoskold method must be adequately taken into account, otherwise false data will be obtained that will lead to financial losses.
About odds
The fact is that the methods under consideration do not exist on their own in a vacuum. A large role in their use is played by the coefficient of capitalization and return on investment. The first is used in assessing risk and displaying invested and received funds. The larger it is, the more profitable business is offered. True, you must be careful. The higher the profits promise, the more likely that the attendant risks will transfer from the status of something ephemeral to a very real thing.
Still worth mentioning is the return on investment ratio. It is used to show the profitability or loss-making of a certain investment as a percentage. His formula is as follows: (income - losses) / amount of investment * 100%.
What difficulties may arise?
For all the apparent external simplicity, there may be certain hiccups. For example, sales prices are opaque information. Therefore, there may be differences between the ratings and the actual results. It is best to use mathematical models in a stable market. Interestingly, deviations are provided when moving in both directions. For example, with market growth, the capitalization ratio will decrease. Of course, it cannot be said that improving the parameters is a bad deviation. But it leads to the fact that the mathematical model used must be adjusted.
We should also mention the use of borrowed funds. After all, alas, it is not always possible to manage exclusively with your own finances. In this case, it is necessary to use the concept of net operating income for one time period and the price of reversion is not calculated. If borrowed funds were used, then it is better to pay attention to the method of related investments.
Specificity to Consider
Now let's talk more about applied aspects. It is always necessary to calculate the basic questions. If you don’t like the answer, then this is an occasion to think about the appropriateness of the actions taken.
For example, can the cash flows of an investment project compensate for the investments made and make a profit? Consider a very simple option. A man transfers money to the bank and opens a deposit. After the expiration of the contract, you can get both the principal amount and the interest due. Of course, if the bank does not go bankrupt. But in this case, you can count on maintaining the main amount if it does not exceed the maximum established by law. Therefore, you have to worry only about the reliability of the banking institution and the proposed interest rate. But if the cash flows of the investment project are aimed at acquiring real estate, then care should be taken that the investments are compensated. That is, receiving a deposit of 10% for this case is clearly not enough if the project is planned to work for ten years. Ten percent of the profit is possible only if the return on investment is 20%. If less, then the payback period will increase. And this will make the project less attractive. And so twenty percent is enough to send half to reimburse the investment, and the remaining 10% to be considered their deserved income.
Conclusion
So the methods of Hoskold, Ring and Inwood are considered. And along with them, it was evaluated how the reimbursement of investment capital is calculated. Mathematical calculations will allow you to find out how much time you need to wait until the capital is reimbursed and profit is made, what will be its final size. Although it should be borne in mind that in solving real problems everything will be somewhat more complicated than discussed in the article. The mathematical formula can be modified to take into account certain points in order to minimize the likelihood of financial losses.