Expected Rate of Return
Expected rate of return is the estimation of profit which investors receive from investment over a period of time. In order words, it is the growth of investment after a month, quarter, or year. It will be calculated by the potential outcome and possibility of each outcome then sum all of the results together.
Many investors are looking for good investments that will provide high returns. However, it is important to remember that there is no such thing as a guaranteed investment. While it is possible to find investments with the potential to earn a high return, there is always the risk that the investment will not perform as expected. For this reason, it is important to carefully research any investment before putting money into it.
When evaluating an investment project, there are many methods that can be used in order to determine its viability.
The expected rate of return is the significant method used in the financial industry in order to decide whether a certain investment is worth making or not. This method is based on the principle that the higher the risks associated with an investment, the higher the potential return should be in order for that investment to be considered worth making.
For example, if somebody is considering investing in a new business venture, they would typically expect to see a higher return on their investment than if they were investing in a more established company. The expected rate of return can therefore be seen as a way of balancing out risks and potential rewards when making investment decisions.
Expected Rate of Return Formula
Example
Mr A decides to purchase an asset cost of $ 100,000 which includes the relevant cost. After 3 years, he sells the same asset for $ 150,000. Please calculate the rate of return.
Rate of Return = (150,000-100,000)/(100,000) = 50%
Expected Rate of Return Approach
Probability Approach
ERR can be calculated by a weighted average of all possible outcomes and their probability.
ERR = (P1*R1) + (P2*R2) + (P3*R3)+….+(Pn*Rn)
P: is the probability of an outcome
R: is the rate of return of the one outcome
n: is the number of all possible outcomes
Example
Company A is evaluating the investment opportunity which will be a huge project for them. Base on the project manager, he has estimated the following result and their likelihood. There are four possible results and each of them will generate a different return.
| Outcome | Probability | Rate of Return |
|---|---|---|
| A | 30% | 50% |
| B | 50% | 30% |
| C | 20% | 70% |
ERR = (30% * 50%) + (50% * 30%) + (20% * 70%) = 44%
Limitation of Expected Rate of Return
When calculating the ERR using any approach above, the result will never be exact. It is just the estimation using historical data that cannot predict the future result. It is a good start to evaluating the investment result, however, it cannot tell the real outcome when the risk will change over time.
Moreover, the RRE does not include any risk involved when we make an investment in a certain asset. Both risk and return are always attached together. If we want to get a higher return, we must face high risks as well. There is no such kind of investment that produces a high return without a big risk.
Besides that, ERR uses only historical data which will be expired shortly in our modern world. It is a good place to start, but relying too much on it will put us in a risky position. In the technology era, the world is moving very fast, the next movement may not follow the trend.
Benefits of Expected Rate of Return
- When making any investment, it is important to consider the potential return on investment (ROI). This metric provides a way to compare the risk of an investment against the probable return, allowing you to make more informed decisions about where to allocate your resources. For example, if you are considering investing in a new piece of equipment for your business, you would want to compare the ROI of that equipment against other potential investments. If the equipment has a high ROI, it means that it is a relatively low-risk investment with a good chance of providing a positive return.
- The expected rate of return is a central concept in finance and investment. Simply put, it is the amount of money that investors expect to earn from a given investment over a specific period of time. For example, if a stock has an expected rate of return of 10%, this means that investors can expect to earn 10% on their initial investment each year. While expected rates of return can be helpful in making decisions about where to invest, it is important to remember that they are only estimates. Actual returns may be higher or lower than the expected rate, so it is important to factor in risk when making investment choices.
- When making investment decisions, companies need to consider the expected rate of return. This is the estimated probability of gain from an investment, which allows companies to make long-term plans by considering the potential risks and rewards. The expected rate of return is influenced by a number of factors, including the current market conditions, the company’s financial situation, and the investor’s own risk tolerance.
Conclusion
The expected rate of return is the percentage of anticipated return that the investor gets after a certain time. It suggests whether the investing amount will bring positive or negative return outcomes. The ratio is a widely used concept in financing and it is important to understand how it works before making any investment decisions.
For example, if you are considering investing in a new company, you will want to know what the expected rate of return is for that company. This information can help you determine whether or not the investment is likely to be profitable. Additionally, the expected rate of return can also be useful for evaluating the performance of an existing investment.
If your investment is underperforming, you may want to consider selling it and reinvesting the proceeds into a different venture with a higher expected rate of return. Ultimately, the expected rate of return is just one factor to consider when making investment decisions; however, it can be a helpful tool for assessing risk and potential rewards.