What it means
When you invest in shares, property, equipment or a business project, the return is the extra money you end up with. Expressed as a percentage of what you put in, and before tax is paid on it, that is the pre-tax rate of return.
It is the headline number you see quoted on savings products, bond yields and project proposals. It matters because it is simple and comparable.
A manager comparing two proposed projects can rank them by pre-tax return without needing to know each investor's personal or corporate tax position. That is useful in a company where different business units face different tax rules.
The catch is that pre-tax return overstates what you actually keep. If gains are taxed at 25%, a 10% pre-tax return becomes roughly 7.5% after tax.
Two investments with the same pre-tax return can therefore leave you with very different amounts, depending on how each type of income or gain is taxed. In business, pre-tax return is often used for early screening, with after-tax analysis added once a project looks promising.
Lenders and investors also look at it when assessing whether a project can cover its funding costs. As long as you remember what it leaves out, it is a good first filter.
A common variant is the annualised pre-tax return, which converts gains over a different period into a yearly rate. Fees, inflation and risk are separate matters again, and a high pre-tax figure does not mean a good investment.
Always ask what has been deducted and what has not. Remember also that the return should be compared with the cost of the money you use.
If a company borrows at 8% and a project returns 6% before tax, the project destroys value even before tax is considered. Many firms set a hurdle rate, which is the minimum return a project must offer before it is approved.
In practice
Real-world examples.
Example
A landlord buys a rental flat for $300,000 and collects $21,000 of net rent in a year before tax. The pre-tax rate of return is 7%. The landlord compares it with a bond yielding 5% before tax and decides the property is more attractive.
Example
A founder weighs a $50,000 advertising campaign expected to deliver $65,000 of extra profit before tax. The pre-tax return is 30%. The founder approves it because it beats the company's 20% hurdle rate.
Example
A pension fund, which pays no tax, compares two bond funds with pre-tax returns of 4.5% and 4.8%. Since tax does not apply, the pre-tax figures are the ones that matter and it chooses the second.
Formula
Calculation
Pre-tax rate of return = (gain before tax / amount invested) x 100%.
A company spends $400,000 on a new packaging machine. In its first year the machine saves $60,000 in labour and adds $20,000 in extra sales margin, giving a pre-tax gain of $80,000. Pre-tax rate of return = $80,000 / $400,000 = 0.20, or 20%. If tax is charged at 25%, the after-tax gain is $80,000 - $20,000 = $60,000, which is a 15% after-tax return. Compare this 20% with the cost of funding: if the company borrows at 8%, the project clears that hurdle by 12 percentage points on a pre-tax basis. The spare margin gives room for tax, maintenance and the risk that savings are lower than planned.Case study
Seen in the real world.
Fernhill Logistics is a fictional company created for this illustration. Its managers had two proposals: a $500,000 warehouse upgrade and a $500,000 fleet of delivery vans, each forecast to return $100,000 a year before tax.
On a pre-tax basis both showed a 20% return, so the board saw them as equal. The finance team then pointed out that the warehouse upgrade qualified for a larger tax allowance, so its after-tax return was higher.
The board chose the warehouse upgrade. The lesson in this illustrative story is that pre-tax return is a good starting point, but the decision is only finished once tax is brought in.
Watch out
Common mistakes.
- Treating the pre-tax return as the amount you will actually keep. Tax, fees and inflation all reduce what ends up in your pocket.
- Comparing investments taxed differently on pre-tax figures alone. Interest, dividends and capital gains are often taxed at different rates.
- Ignoring the time period. A 10% return over three years is not the same as a 10% return per year.
Questions
People also ask.
How do I convert a pre-tax return to after-tax?
Multiply the pre-tax return by one minus the tax rate, so 8% at a 25% tax rate gives 8% x 0.75 = 6%.
Is pre-tax return the same as ROI?
It is a type of return on investment (ROI) measured before tax, and many people use the terms loosely.
When is pre-tax return enough?
It works well for early screening and for tax-exempt investors, but taxable investors should also look at the after-tax figure.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%