The rate of return (R) is used as the discount rate for future cash flows to account for the time value of money. Companies may often have different ways of identifying the discount rate. Common methods for determining the discount rate include using the expected return of other investment choices with a similar level of risk, or the costs associated with borrowing money needed to finance the project.
If the NPV of a prospective project is positive, the project should be accepted and the investment would add value to the firm. However, if NPV is negative, the project should probably be rejected because the investment would subtract value from the firm and cash flows will also be negative. Factors that affect the rate of return:
Macroeconomic conditions- Economic slowdowns lead to low employment, which usually means lower profits and stock prices. The resulting weakness in the stock markets could improve bond prices as investors move funds to the relative safety of bonds. Rapid economic growth can lead to higher interest rates which would makes credit more expensive.
Risk factor-changing regulatory environment, competitive pressure. However, the required rate of return is higher when the risk is high and vice versa.
Regulations – deficits reduce government flexibility and may results in higher borrowing cost for businesses.
Political instability- increases risk for investors and businesses and lower their confident level because low visibility of rate of return. Investors would try to avoid countries who change government frequently.
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