Question

Assume that we believe that the expected cash flow is $500 and the expected rate of return (cost of capital) is 20% from a project. This is a 1-year project. Is it worse to commit an error in cash flows or in cost of capital? Does your conclusion change if this is a 50-year project?

Answer 1

If the cost of capital is 20% and the expected cash flows is 500, then, it is given that it is just an one year period so it will be worse to commit a mistake in the cash flow because cash flows are making more impact than the interest rate because it is a shorter time span and any mistake in estimation of cash flows will be leading to a very high fluctuation in the net present value of project whereas, value estimation of a wrong cost of capital would not lead to much fluctuation due to a shorter span of time.

When there would be a change in the product life time and it would be a 50 year project, then Rate of interest will be playing a very crucial factor because this is a very long duration project and even 1% change of Rate of interest can be having a complete different prospect of the acceptance of the project, so in that case it would be worse to commit an error in consideration of cost of capital because even 1% change of interest can be causing huge swing of inflows and outflows and hence we will be trying to to look at better estimation of cost of capital in order to have a better discounting rate and better acceptance of these projects so that cash flows as well as cost of capital can be predicted accurately and project should be accepted which are genuine.