What does the paragraph dealing with economic rate of return mean? There is one that says that the economic rate of return is equal to the required rate of return. Can anyone explain this relationship?
Not too surprisingly, all this is saying is that after you discount the cash flows (at the required rate of return) to get the NPV, then each year the cash flow minus the change in market value gives a net return on the beginning market value that equals the required rate of return.
Suppose that you invest $1,000 to get annual cash flows of $400 per year for four years; your required return is 10%. The NPV is $268, so the initial market value is $1,268.
- Year 1: Market value decreases by $273 to $995, economic income is $400 − $273 = $127, so the return is $127 / $1,268 = 10%.
- Year 2: Market value decreases by $301 to $694, economic income is $400 − $301 = $99, so the return is $99 / $995 = 10%.
- Year 3: Market value decreases by $331 to $364, economic income is $400 − $331 = $69, so the return is $69 / $694 = 10%.
- Year 3: Market value decreases by $364 to $0, economic income is $400 − $364 = $36, so the return is $36 / $364 = 10%.