Thursday, October 28, 2010

How to calculate the "right" ROI?

ROI or Return on Investment is the simplest way to measure the performance of an investment.

What is "A"?
  • can be the gross return of an investment
  • can be the net of expenses of an investment
  • can be the profit after tax of an investment
  • can include the unrealised gain (share price increased)
What is "B"?
  • can be the cost of an investment (i.e. the contract price of the property)
  • can be total cost of an investment (all cost added up)

Example 1:
Saving in EPF Account
Tax bracket: 24% (i.e. any extra income will be tax at 24% or higher)
Dividend for year 2009 is RM5,650 based on opening balance of RM100,000
No expenses
No tax
Therefore, ROI = 5.65%

Example 2:
Tax bracket: 24% (i.e. any extra income will be tax at 24% or higher)
Rental income for shop bought by cash for RM450,000 (incurred legal fee and stamp duty of RM12,000)
Gross income collected from tenant during 2009 is RM36,000 (RM3,000 per month)
Maintenance fee paid to Manager of the builder RM3,600 (RM300 per month)
Quit rent, assessment and fire insurance for 2009 total RM2,850
Repair and maintenance RM2,500 incurred during year 2009.

Agent who sold you this investment told you that your ROI is 8.0% (RM36,000 / RM450,000)

However, your ROI = 27,050 / 462,000 = 5.85%, am i right to say so?
A = RM36,000 - RM3,600 - RM2,850 - RM2,500 = RM 27,050
B = RM450,000 + RM12,000 = RM462,000

However, you need to take into tax effect, as good citizen we need to pay tax on the rental income according to Section 4c of Income Tax Act 1967.

Therefore, ROI = (27,050 * 76%)/462,000 = 4.45%

Wow! We have 3 ROIs here, 8.0%, 5.85% and 4.45%

Example 3:
Investment in REIT (purchased through my trading account with Hong Leong Investment Bank) total RM2.00 x 50,000 units) = RM100,600 (including transaction costs of RM600) as at beginning of year 2009
Net dividend received during year 2009 = RM6,778
Dividend received has been taxed at withholding tax rate of 10%.

Since it has been taxed under withholding tax, you will not be taxed again at 24%.
Therefore, ROI = RM6,778 / RM100,600 = 6.74%

However, because the share price increase during the year from RM2.00 to RM2.11 as at 31.12.2009, therefore the ROI = (RM6,778+RM5,500)/RM100,600 = 12.20%

All above examples are based on whole year basis, therefore no need to annualise it.