Introduction
The Critical Ratio Method is an economic analysis tool used to measure the effectiveness of alternative projects and investments. This technique evaluates a project’s return on investment (ROI) by comparing the rate of return to the risk of the investment. It’s not a tool used to determine the feasibility of a project or the amount of capital needed to finance it, but to evaluate the anticipated investment results.
Concept
The Critical Ratio Method considers both the expected rate of return of a project or investment and its volatility. The rate of return is the amount of money earned or lost on an investment and is expressed as a percentage. Volatility, on the other hand, measures the fluctuations in the value of an investment over time and is considered when investors are trying to weigh the risk associated with an investment.
Calculation
The Critical Ratio is calculated by dividing the rate of return by the volatility.
CR = Rate of Return / Volatility
Therefore, a higher critical ratio indicates a higher expected return for a given risk level.
Example
Bob wants to evaluate two potential investments, A and B. Investment A has a rate of return of 10% and a volatility of 5%, while Investment B has a rate of return of 7% and a volatility of 4%.
CR (A) = 10% / 5% = 2
CR (B) = 7% / 4% = 1.75
The higher critical ratio (2) indicates that Investment A is the better investment choice, providing both a higher rate of return and a lower level of risk than Investment B.
Limitations
The Critical Ratio Method does not account for the time it takes for an investment to mature, which can affect how an investment performs. It also does not include other types of risk, such as political or industry-specific risks.
Conclusion
The Critical Ratio Method is a useful tool for evaluating the relative risk and return of different investments or projects. It’s a simple but effective method for assessing how much risk an investor is willing to take in order to achieve a desired rate of return. However, the Critical Ratio should not be the only tool used to analyze an investment; other factors, such as the time to maturity and other types of risks should also be taken into account.
