Question

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Elaborate on the concept of compounding. Discuss how to calculate the Present Net Value and the significance of this indicator for decision-making.

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Answer 1

Solution -

Compounding is one of the most progressive concepts of investment. Compounding is a process or a mindset of investing one’s earnings back into the investment cycle so as to generate further earnings. Every asset has certain benefits and earnings attached to it. There are two end-uses for the earnings from the asset. One is to withdraw the earnings and put them for consumption and the other one is to reinvest these earnings back into the business to generate further more income from previous levels. This type of reinvestment leads to an increase of principal amount and helps to generate larger income which further deployed into the principal has an exponential increase in the earning capacity of the investment. In a more technical term compounding is beyond linear growth. The concept of the future value of an asset relies on the compounding effect. The initial principle along with the rate of return and the frequency of compounding together play an important part in defining the future value. Mathematically compounding can be represented as -

FV = I x (1+r)ⁿ

FV = Future Value

I = Initial Investment

r = Rate of return

n = Number of compounding periods

In simple terms, Net Present Value (NPV) is all about calculating the current value of the future value of an investment. It accounts for the time value of money and helps to ascertain the present value of future earning by applying the discount rate. Mathematically the net present value is calculated by -

The summation of – NR/(1+r)^t

NR = Net Return

r = discount rate

t = number of periods

The key parameter here is the discount rate which helps to discount the future cash flow for the risk, opportunity cost, market factors and also other factors that reduce the probability of future earnings or increase the options of present earnings.

For making a decision with the NPV we need to remember a thumb rule –

If NPV is positive then the project must be executed and if NPV is negative then the project must be rejected. If NPV is zero then the project does not make any financial sense but can still be carried out if the project is driven for a strategic objective. it is an important concept as it helps to make a rational go or a no-go decision on a project from the financial perspective.