Management and the Technology Professional – B302
Financial analysis using interest and present values
Time value of money is a fundamental concept.
Several factors contribute to the determination of a
rate of interest.
Simple interest
Let
P be invested at a fixed interest rate of
R per investment period.
Let that interest be added just once at the end of an investment duration consisting of
N investment periods. Let
V be the total value including the investment and interest earned.
Compound interest
Let
P be invested at a fixed interest rate of
R per investment period.
Let that interest be added at the end of each investment period, which is called
compounding. Let
N be the number of investment periods during the whole investment duration. Let
V be the total value including the investment and interest earned.
Period of interest and compounding frequency
A rate of interest is assigned for a specific period of time, e.g. annual, quarterly, monthly or weekly. If the compounding period
is not the same as the period of interest, then you need to calculate the
effective rate of interest.
If we use the current bank loan interest rate from Natwest of 8.4% per annum, then we can calculate the effective rate for 6 months by solving for this equation where the variable W is the 6-months rate and the power of 2 represents the fact that there are 2 six-months investment periods in 1 annual period:
(1 + W)^2 = (1 + 0.084)^1
6 months discount rate = W = (1 + 0.084)^(0.5) – 1 = SQRT(1 + 0.084) – 1 = 0.041 = 4.1%
Present value practice example
It takes 9 months to finish installation of Skype software. The total cost at the end of 9 months is £500. What is the present value of that expense?
A year after the installation is completed, the company telephone expenses is reduced by £800. What is the present value of that savings?
Although the duration and amounts are examples, you can use your own experience and research to select realistic durations, amounts and discount rate.
Payback capital analysis method
The
payback period is the length of time required for the
net cash inflows (e.g.
income) from a project to reach an equal amount to the
original cash outlay (e.g.
investment).
The decision rules when using the payback capital analysis method are:
- The most important measure of success in investment is the recovery of cash investment. Accept the project with the shortest payback period.
- This method does not have a rejection rule.
Net present value (NPV) capital analysis method
The
net present value (
NPV) of a project is equal to the present value of the cash inflows (e.g. income)
minus the present value of the cash outflows (e.g. investments or payments). Cash flows are calculated using
a specific discount rate. The process of calculating the present value is called
discounting.
The decision rules when using the
net present value (
NPV) capital analysis method are:
- Accept a project for which the net present value is positive.
- Reject a project for which the net present value is negative.
- Where the net present value is zero, the project is acceptable in meeting the cost of capital, but, gives no surplus to its investors.
