When making an investment, it is critical to analyze the potential return or profit that could result. By finding the future amount that results from an investment, investors can evaluate if the opportunity meets their financial objectives. This involves estimating cash flows, incorporating appropriate discount rates, and utilizing financial formulas to quantify results. For example, an investor may want to know how much they would have in 20 years if they invested $20,000 per year at a 7% annual return. By forecasting the future value using the appropriate formulas, they can find the $819,909 amount that would result. Having clear visibility into potential outcomes empowers smarter investment decisions.
Calculate future and present values to find investment results
Two key formulas for finding investment results are future value (FV) and present value (PV). FV calculates the amount an investment will grow to in the future based on periodic deposits, interest rates, and time. For instance in Practice Problem 2, an FV formula finds the $819,909 future sum from annual $20,000 investments over 20 years at a 7% return. Meanwhile, PV calculates the amount needed to invest today to reach a specified future amount, incorporating the discount rate and timing of cash flows. Problem 4 demonstrates using PV to find the $56,044 initial investment required to have $75,000 in 5 years at a 6% return.
NPV quantifies net benefits of an investment opportunity
An investment’s net present value (NPV) calculates its value in today’s dollars by discounting all expected future cash inflows and outflows at an appropriate rate. By directly comparing NPVs, investors can identify the best investment choices and make smarter capital allocation decisions. Problem 5 illustrates using NPV to find that $772,173 is the fair lump sum payment today equivalent to receiving $100,000 annually for the next 10 years at a 5% discount rate. So NPV provides the tangibly quantified net benefit amount resulting from a potential investment.
IRR solves for the breakeven return rate of investments
An investment’s internal rate of return (IRR) is the discount rate that results in an NPV of zero. By setting NPV equal to zero and solving for the discount rate, IRR indicates the breakeven return threshold where the present value of future cash flows equals the initial investment. In Problem 6, IRR is used to find the $52,585 and $73,592 amounts that should be paid respectively for two instruments with different cash flow schedules given an 8% required return. Here, IRR helps assess if the investments could potentially yield the target return and meet objectives.
Profitability index measures return per dollar invested
The profitability index calculates the ratio of an investment’s present value of future cash flows to initial outlay. It quantifies the amount of value created per dollar invested, with higher ratios indicating greater efficiency. A profitability index above 1.0 means the return exceeds the cost of capital and a value-adding investment results. Though best for ranking constrained projects, profitability index provides another metric to gauge and compare the tangibly resulting returns of different investment choices.
In summary, financial formulas like future and present value, NPV, IRR, and profitability index allow quantitatively finding the return amounts resulting from investments. By calculating resulting values, investors gain critical insight to inform capital allocation and evaluate if opportunities achieve targeted objectives.