Expected Rate of Return

The expected rate of return is a collaboration of calculations that show what the return might be on an investment. It is calculated before investing, to yield another piece of decision-making information to those looking at an investment.

It is most commonly discussed in a conversation about the model of return-on-investment (ROI) rate. This model is used to provide information on decisions affecting business operations. Business conversations initiated aboout the impact may ask, How much will it decrease costs? How much will it increase revenue? What will it cost to implement? How long before we see a “return”? What is the “expected rate of return” on the investment? All these factors help predict, with reasonable accuracy, the “rate of return” on an investment.

To complete the process, the expected rate of return considers many variables. Some examples are decreasing costs by reducing labor, increasing revenues with new abilities provided by the investment, impact on employees, impact on others outside the enterprise, impact cost on utilization of resources considering existing capacity, impact on inventories and accuracy, capital costs, operational costs, impact on quality, growth rate, current size of enterprise, degrees of change, and others.

Typically a target is established that the expected rate of return should meet for the investment to be considered successful. For example, if the expected rate of return is to have the investment pay for itself in three years, then the return should show a 100% payback in three years, considering the time value of money.

If a enterprise made an investment of $100,000 in its investment portfolio and this investment paid an annual [Page 202]dividend of $10,000 a year, the expected return would be 10% (expected rate of return = $10,000/$100,000 = 10%).

The advantages of calculating the expected rate of return lie in estimating future cash flows and financial impact. The disadvantages are that even though analysts are blessed with enormous amounts of historical data, the analysts assume that the future will be like the past.