The Net Cash Flow, Essay Example

Often, the expected rate of return on new projects is considerably higher than the actual return on investment. Even though most firms tend to deal with projects with a financial return greater than an acceptable figure, it usually does not occur. The reason behind this is analysed in relation to the building of a new factory to make widgets, and is discussed herein. This evaluation takes into consideration why financial measures of intended performance fall short of actual performance.

The expected rate of return, commonly known as the net present value (NPV), takes into consideration a number of factors. In this case, the building of a new factory to make widgets requires the net cash flow, the discounted rate of return, and the time of the cash flow. These three parameters assist in calculating the net present value. The formula for identifying the NPV is as follows:

Firstly, the net cash flow would be projected as the expected financial return after the building has been completed. Secondly, the discounted rate of return is also known as the opportunity cost of pursuing a similar project in the market, which takes into account the financial risk of the new project. Thirdly, the time of the cash flow would be the estimated timeframe for the building to be completed and begin to earn a steady cash flow; this would come from the sale of the widgets.

The discounted rate of return is one of the most difficult to identify amongst the three parameters; which is one of the reasons why the internal rate of return (IRR) formula is used to calculate this. The internal rate of return is calculated using a second set of parameters. These include the standard approximation of the IRR and the NPV, as shown above. This formula for the IRR is shown here below:

The approximation of the internal rate of return, as symbolised by the ‘r’ here, is based on the average market rate. The NPV, as taken from the previous formula, can simply be substituted here. Finally, the discount reflects the amount of time it takes for the return on investment to eventuate. In this case, all the parameters are located inside the problem itself, and can easily be input for each value.

As for this situation, the new project for building a factory to make widgets is seen as under the indicated financial return of 15%. This is mainly because new products often do not have enough capital or financial growth to exceed the expected rate of return with an actual rate of return that is larger, since most projects do not break even within the first year. In addition, the investment into building such a factory in reality is sizeable. This is such that most new projects are not completed.

The projects that are completed move forward with a certain level of financial risk. This is because the outcome of the project is not known until completed. The expected rate of return or cash flow that is indicated is a conservative estimate. Most projects have an actual return of about eight to ten percent, as indicated. Therefore, any new project that is undertaken, such as the building of a new factory to make widgets, comes with financial risk. However, as a rule of thumb; the greater the risk, the greater the reward.

In this case, the actual return on investment is the amount needed to invest into the new project, in comparison to the alternative, which would be another project. This is known as the opportunity cost, as mentioned earlier. When investing into a new project, such as building a factory, the actual rate of return would be approximately eight to ten percent; so the opportunity cost would be up ten percent or even fifteen percent, which would require one to invest into an alternative project. Such a return would compensate the investor for making the investment. This can be calculated using the NPV or IRR formulas above.

The expected rate of return, however, is the average of all the possible outcomes from the investment into the said factory. It is the most likely return from an investment based on the financial risk. Nevertheless, the expected rate of return is an educated estimate; it is not guaranteed. This return is based on the expected price of the widget and the current price in the market at which it is selling. If the widget is selling at a high price, the return is greater; but if it is not, the return is less.

This scenario also involves a lot of estimations and investments based on risk. If the factory is built and the widgets are made and correctly valued as a result, the actual return on investment would equal the expected rate of return. However, if the widget is overvalued, then the actual rate of return would be more than the expected rate of return. Investors into such a project would rather sell the widgets than keep them. On the other hand, the widgets would be undervalued if the actual rate of return is less than the expected return. Investors into such a project would rather buy the widgets. Since this cannot be done with such a project, the investor would gauge the risk and not invest.

As it can be seen, the primary reason why actual rate of return is often less than the expected rate of return is due to the element of risk. Even financial projections and closely monitored estimations cannot accurately identify the level of risk. The risk increases when a project is new, has limited capital, and incorporates a sizeable investment. Therefore, if taken on face value, such a project should not be invested into. However, if widgets are in high demand, than a building a new factory to make widgets is justified.

For such as scenario, it should be noted that as widgets are often a higher selling commodity, there would be a greater demand for widgets than for an alternative commodity. Also to be taken into account is the current market and the risks involved. Once all factors are considered, than a final decision can be made. The onus is on the investor to determine whether or not to invest.

Conclusion

In summary, financial measures of intended performance often fall short of actual performance due to financial risk. Although net present value of an investment and the internal rate of return assist in determining estimation on the said project, the actual investment is made by the investor. If taken on face value, such a project should not be invested into. However, if widgets are in high demand, than a building a new factory to make widgets is justified.