Before we begin the discussion you would need the tools required to perform complex net present value calculation.
Download the tool here that will assist you with the task
If you ever been to places like Yahoo Answers! or have read through a sample of textbooks on Google Books on the topic of financial management then you would know for sure that going to a business school is a waste of time value of money.
The lecture begins with telling students about discount factors that reflect the value of expected payments in its present or current terms. Students are given a handful of examples with a set of payments and are shown how each of the payment is discounted using the discount factor and sum of such discounted cash flows is the net present value of the investment.
The assignments are then handed out and students rush to Yahoo Answers! or MathHelpForum, MathHelpBoard, MyMathForum and want you to help solve for the net present value problem.
The key reason why so many business students don't even have the minimum math skills required to solve complex finance math problems is largely due to the use of software programs by the business teachers in solving such problems. Even those programs such as Excel spreadsheet has issues of their own when it comes to financial calculations. This makes sense as most of those who were consulted by Microsoft for finance formulas were the same teachers at business schools with only rudimentary knowledge of finance math.
Not that I have any money to go back to school, even if I did I wouldn't bother attending such schools where all you get at the end is a piece of paper called a degree testimonial that entitles you to hold a job for life securing yours and your children's future.
When you have ample time to kill, someone like me would go on a thinking binge learning on their own. Briefly reading through material found on the internet and then brainstorming to extend the ideas that were learned.
Financial analysis is the process by which an analyst processes the data about investments and provides information or knowledge that helps the investor with decision making. Such information is crucial and critical; there is no room for error or else it will cost the investor an arm and a leg off his invested sum of money.
There is a universal appeal to using NPV - net present value as the key indicator of profitability. Forget the investor for a second, all of us no matter what profession we engage in regardless of education, skill, race, gender, religion, sexual orientation, country of origin know that the more of money we have the more happy it makes us. Thus we all know about NPV - without even knowing it's name since a net present value is the money amount we stand to gain or lose when undertaking an economic activity. This is one reason you would see a mile long queue of people at the local grocery store in New York State who are all willing to buy a 1 lottery ticket in hopes to gain a net present value in amounts of millions of dollars.
But then finding net present value requires much more than what they taught Melissa who went to CUNY - City University of New York, or Matthew who went to UCLA - University of California at Los Angeles to study Business Management.
To begin investigating net present value, you would to understand what they call an annuity that happens to be a series of periodic payments or receipts. Your monthly utility or phone bill is an example of an annuity so is the annual college tuition of your child. Annuities have durations and timings, for instance a house rent is due at the start of month whereas a utility bill is due at the end of the months once service has been consumed. This divides the annuities into an annuity due (start of period payments) and ordinary annuity (end of period payments). There is a slightly different type of annuity where payments do not begin immediately at the start of end of period, such payments are delayed by a length of time. Such annuities are referred to as a deferred annuity. Now you are more likely to pay the house rent or utility bill for a longer period of time as you must pay the cost of living. On the other hand, you would only be paying for your children's college fee for a maximum of 4 or 6 years. As the duration of earning college degrees are of short durations as compared to consuming services or goods that you need on a daily or periodic basis as long as you live.
Money is only lent when the lender can receive a sum that is higher than the amount that was loaned to offset the opportunity cost had the lender decided to keep the money for herself. She would only be willing to let go of the money at present if you could receive a sum of money that will include her opportunity cost. But she would only be lending if it is for certain that her money will be returned. For some borrowers it may be difficult to fulfill the obligation as they have a bad credit history. Even though most lenders would shy away from those with history of not making repayments on time yet since money has to stay in circulation they would want to ensure the safety of their investment. Thus lenders such as Ms. Linda Lender from Lynwood, Long Island, NY would add a risk premium to the interest rate. And you will always find at least one borrower who is willing to pay almost any interest rate as long as they don't have to repay the money themselves. Take for example, the recent dual trance of EuroBond issued by Federal Government of Pakistan. Their finance minister who was under stress to increase the foreign reserves on the demands of IMF - International Monetary Fund to be eligible for the next loan payment, went on a road show to key money markets in London, New York, Los Angeles, Singapore and Dubai. They were only seeking half a billion of US dollars yet they came away with selling a debt four times the size of the original plan. The cost of such debt didn't bother their finance minister who agreed to pay a yield of almost 8% whereas yield on US Treasury bonds of similar duration was roughly 2%, or one fourth the rate they accepted to pay. So there you have it, one borrower who is willing to pay any price to get the loans as long as they don't have to repay the money themselves and the standard of living of ordinary residents in their country can best be described as under a 1 per day income people.
So now that you understand the cost of debt, it brings me to the topic of use of interest rates in determining the net present value of an investment. The cash flows expected into the future need to be discounted at the discount rate to reflect the real value of such an investment at present. Such discount rates tend to change over the horizon of the investment due to many factors. For example, in case of the EuroBond issued by Pakistan that was issued at an interest rate of 8% would see erratic behavior. For instance, if in the coming year the country fails to redeem the par value of the previously issued debt that will come to maturity. If at that time, the country finds itself short on cash yet it must repay the old debt, it will have very few options to get more funds and at the same time be able to make the interest payment on the EuroBond. In such cases, the investors holding current debt or those who will be approached to buy new debt would obviously demand an interest rate much higher than 8% to ensure the return of their investment. Thus the rate may jump from 8% to say 24% for any new funds that they would seek. But as I stated earlier Ms. Linda Lender will always be find at least one borrower who is willing to pay "any" interest rate as long as they don't have to repay such debt themselves. Now those under a 1 per day residents would turn into under 50 cent crowd so they should have realized what such people are worth. In case they haven't figured it out, such people are worth roughly fifty cents.
Now that you learned that Ms Linda Lender demands interest on lending money, the next thing you need to know is how frequently does she want to accumulate such interest. If all she wanted was an annual interest payment, that would be fine but Ms. Linda is a shrewd lady who recalls from her finance management course taken at ACIMG - American Capitalist Institute of Money Grabbers that she could earn more in interest by increasing the compounding frequency. For example, rather than accumulating interest on her loans on a yearly basis, she could demand interest to be paid twice a year. And it gets really sweet when you add more sugar to the drink and Ms Linda knows that by further increasing the interest accumulation to monthly frequency will lead to more dough at the bank vault. And we all know Ms Linda Lender likes Pepsi Max, a caffine product, that gives her the ultimate jolt. Putting the nuts and bolts together now Ms. Linda wants the maximum interest accumulation possible by demanding an infinite compounding of interest. But who said! Pepsi/Coke what's the difference? But those who drink Coke like Rock N' Roll whereas those hooked on Pepsi prefer Rapper Jazzy G. This part of the lecture ends with the conclusion that to perform the net present value calculations, you must uses various compounding frequencies of interest that helps the investor to maximize her return on investment. Don't we all do it for money! As I recall the reply from the girl I dated who stated her own valued business principle of "No money! No honey!". I couldn't figure what she meant till I ran out of money and never seen the honey ever since 1992 when I lived in Greenburgh, New York.
But they inflate the figures to earn false profits. Cost of living increases with a "Passage through India" or through time. Thus a correct net present value would ensure that expected gains or losses in the future reflect the effect of inflation. Similarly rather than the inflation in prices the reverse may be true in certain markets like Japan that see a persistent deflation across all sectors of the economy thus leading the finance minister to take corrective class action to avoid lawsuits. Now it should be clear to you that when finding the net present value of an investment, you must consider the rise and fall of prices at a future date. Remember what the President said in 1988, "It's the economy stupid!" and the same President also claimed that opposition had a Voo doo economics policy. The eight billion US dollars granted to Haiti in the aftermath of the 2010 earthquake is like throwing money into a black hole for which you expect no return on investment. This reminds of my own investments confined to a location where the State takes all your profits and gives spare change and keeps the bigger chunk of the Top 100 American pie charts on the billboard.
But timing is crucial, and you should be able to handle loan repayments for various time periods. It may be that Ms Linda could wait for a year to receive the first loan repayment. But as she learnt that her luxury apartments in Palm Beach, Florida caught fire damaging the structure of the whole building. Now Ms Linda can't wait for a year as she has to rebuild the apartment to be able to stay in sunny Florida during the Winter to escape the bitter cold in New York. Ms Linda may get pushy and ask you to make payments more frequently, a demand notice was sent from her to the borrowers to start making quarterly payments before another notice was dispatched that said that payment schedule has now changed to weekly loan repayments. Now to find the net present value for Ms Linda, her accountant must learn how to cope with intra-year payment frequencies. This has now added a new dimension in performing net present value calculations to address the use of payment periods having varying lengths.
But as you recall the borrower had a bad history of credit, and now Ms Linda has realized she won't be able to collect the full remaining loan repayments. Ms Linda's attorney had a meeting with the borrower and it was agreed that 60% of the full value of remaining payments can be arranged. This has now troubled Ms. Linda's accountant who has to now cope with the hair-cuts on expected payments. Thus to find the true worth of Ms Linda's investment the earnings have to be trimmed by 40%. This would be possible when the formula for net present value would be adjusted to reflect the possible loss of future earnings.
But Ms Linda didn't realize that her accountant is a thief and without telling Linda, the accountant has disguised the net present value calculation using a rigged rate. This had led to a lower net present value whereas the actual worth of investment was quite higher using the actual interest rate. This is the nature of business where everyone is wanting money for themselves and the investor has been deprived of her real earnings. Now it should be clear to you that rigging the interest rate leads to a lower than actual net present value in contrast to the actual worth using the real discount rate.
Now that the presentation has to come to its conclusion, you would be wondering how to perform such net present value calculations that address all of the issues that have been discussed thus far. To my knowledge, there aren't many software programs that allow complicated math required for such NPV calculation. However there is tadXL add-on for Excel whose latest version 3.0 offers an NPV function that permits such complicated net present value calculations.
Here are the input parameters that are accepted by this Excel NPV function to find net present value of an investment.
tadNPV( rates, inflation, exchange_rates, tax_rates, cashflows, adjust_for_inflation, frequencies, types, compoundings, periods, concentrations, hair_cuts, rate_rigged_by )