Learning About How Your Savings and Earnings Grow Without Interest Expenses
Understanding Pre-Interest Return (PIR) - A Simple Example for Kids
Pre-Interest Return (PIR) is a measure used in finance to assess the profitability of an investment before accounting for interest expenses. It is calculated by dividing the operating profit or earnings before interest and taxes (EBIT) by the total investment made in the project or investment.
Let's take an example to understand PIR better. Imagine you have a small bakery business and you want to assess the profitability of a new oven that you purchased for $5,000. The oven is expected to generate an operating profit of $2,000 per year. You also took a loan of $2,500 to finance the purchase of the oven, and the annual interest expense on the loan is $250.
To calculate the Pre-Interest Return (PIR), you would first need to calculate the EBIT, which is the operating profit before accounting for interest expenses. In this case, the EBIT would be:
EBIT = Operating Profit - Interest Expense
EBIT = $2,000 - $250
EBIT = $1,750
Next, you would divide the EBIT by the total investment made in the project or investment, which includes the cost of the oven and the loan amount. In this case, the total investment would be:
Total Investment = Cost of Oven + Loan Amount
Total Investment = $5,000 + $2,500
Total Investment = $7,500
Now, you can calculate the Pre-Interest Return (PIR) using the following formula:
PIR = EBIT / Total Investment
PIR = $1,750 / $7,500
PIR ≈ 0.2333 or 23.33%
So, the Pre-Interest Return (PIR) for the oven investment would be approximately 23.33%. This means that the investment in the oven is expected to generate a return of 23.33% on the total investment made, before accounting for interest expenses.
The Pre-Interest Return (PIR) is a useful metric for evaluating the profitability of an investment or project without considering the impact of interest expenses. It helps investors and business owners assess the potential return on investment (ROI) of a project before accounting for financing costs. However, it's important to note that PIR does not consider the time value of money or the risk associated with the investment, and should be used in conjunction with other financial metrics for a comprehensive evaluation.
Summarise
Let's explain the concept of Pre-Interest Return (PIR) to kids using a simple example:
Imagine you have a piggy bank where you save money to buy a toy that costs $20. You currently have $10 in your piggy bank, and you want to know how much money you need to save every week to reach your goal of $20.
You decide to save $2 every week. After 5 weeks, you will have saved a total of $10 (5 weeks x $2/week). At the end of the 5 weeks, you check your piggy bank and see that you also have an additional $5 in coins that you collected from doing chores for your neighbors.
Now, you want to know how much money you made from your savings and chores combined, without considering any interest or additional costs. This is where the concept of Pre-Interest Return (PIR) comes in.
To calculate your PIR, you would add the total amount of money you saved and earned from chores (which is $10 + $5 = $15) and divide it by the total amount of money you initially saved (which is $10). In this case:
Total Savings and Chores Earnings = $10 + $5 = $15
Initial Savings = $10
PIR = Total Savings and Chores Earnings / Initial Savings
PIR = $15 / $10
PIR = 1.5 or 150%
So, your PIR would be 150%. This means that you were able to save and earn an additional 150% of your initial savings without considering any interest or additional costs. This shows how much your savings and earnings have grown in relation to your initial savings.
Remember, PIR is a simple way to understand how much you have earned or grown your savings without considering any additional factors such as interest, taxes, or other costs. It's important to learn about other financial concepts as you grow older and start managing more complex finances, and seek guidance from trusted adults or financial advisors to make informed decisions about your money.
In conclusion, Pre-Interest Return (PIR) is a measure of the profitability of an investment or project before accounting for interest expenses. It helps assess the potential return on investment without considering financing costs. By understanding PIR and other relevant financial metrics, investors and business owners can make informed decisions about their investments and evaluate the profitability of their projects.
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