Investing wisely is the key to financial growth, whether for individuals or businesses. Making the right investment decisions requires an understanding of fundamental financial concepts such as the Time Value of Money (TVM), Net Present Value (NPV), Internal Rate of Return (IRR), and Share Valuation. These concepts help investors and business managers evaluate different investment opportunities and choose the most profitable one. In this blog, we will explore these essential financial principles with solved examples and practice questions to help you master the art of investment evaluation.
1. Time Value of Money (TVM): Why Money Today is Worth More Than Tomorrow
The Time Value of Money (TVM) is the foundation of all investment decisions. It states that a rupee today is worth more than a rupee in the future because money can be invested to earn returns over time.
For example, if you have Rs. 1,00,000 today and invest it at 10% annual interest, after one year, it will grow to Rs. 1,10,000. This concept helps us understand how investments grow and why we must consider inflation, interest rates, and opportunity costs when making financial decisions.
2. Net Present Value (NPV): Evaluating Profitability of Investments
NPV is a widely used technique to assess the profitability of an investment. It calculates the present value of future cash flows using a discount rate and subtracts the initial investment cost.
where:
- Ct​ = Cash flow in year t
- r = Discount rate (required rate of return)
- t= Number of years
- C0​ = Initial investment
A positive NPV means the investment is profitable, while a negative NPV means the investment should be avoided.
3. Internal Rate of Return (IRR): Finding the Break-even Discount Rate
IRR is the discount rate at which the NPV of an investment becomes zero. It helps investors compare different projects and choose the one with the highest return. If the IRR is higher than the required rate of return, the investment is considered profitable.
For example, if a company invests Rs. 10,00,000 in a project that generates Rs. 3,00,000 per year for 5 years, calculating IRR will help determine whether the returns justify the investment.
4. Share Valuation: Determining the Fair Price of Stocks
Investors in the stock market often use valuation models to determine whether a stock is undervalued or overvalued. The Dividend Discount Model (DDM) is one of the most common methods:
where:
- P0= Present stock price
- D = Dividend per share
- r = Required rate of return
- g = Growth rate of dividends
If the calculated price is higher than the market price, the stock is considered undervalued and a good investment.
Ready to Improve Your Financial Decision-Making?
Go ahead and try the practice questions provided in this blog to test your understanding and sharpen your financial analysis skills!
Parag is evaluating 3 options for investment of his surplus money of Rs. 15,00,000/- for a period of 5 years.
i. Invest it in a Debenture which gives him a return of 12% compounded quarterly.
ii. Invest in a Corporate Deposit at a rate of 9% compounded bi-annually.
iii. Invest it in a Business Proposal which gives him the following returns.
Considering the risk involved, the discounting factor is considered @ 11%.
As his finance advisor which option would you suggest him. Provide reasons.
Solution:
Investment Evaluation Summary
- Debenture (12% compounded quarterly)
- Final Value after 5 years: Rs. 27,09,167
- Corporate Deposit (9% compounded bi-annually)
- Final Value after 5 years: Rs. 23,29,454
- Business Proposal (11% Discount Rate, NPV Calculation)
- NPV: Rs. 1,58,338
Recommendation
- The debenture investment gives the highest return (Rs. 27,09,167) and is a secure option.
- The corporate deposit yields Rs. 23,29,454, which is lower than the debenture.
- The business proposal has a positive NPV (Rs. 1,58,338), indicating profitability, but it also involves higher risk.
Given the risk-free nature of debentures and higher returns, Parag should invest in the debenture option unless he is willing to take business risks for potentially higher long-term gains.
Practice Problems
1. NPV & IRR Calculation
Ravi has an investment opportunity that requires an initial investment of Rs. 8,00,000. The projected cash inflows over the next 4 years are:
- Year 1: Rs. 2,50,000
- Year 2: Rs. 3,00,000
- Year 3: Rs. 3,50,000
- Year 4: Rs. 4,00,000
The required rate of return is 10%.
- Calculate the NPV of the project.
- Find the IRR and determine if Ravi should proceed with the investment.
2. Time Value of Money – Future Value Calculation
Meera wants to invest Rs. 5,00,000 in a fixed deposit that offers an interest rate of 8% per annum, compounded annually for 6 years.
- Calculate the future value of her investment.
- How much would she get if the interest was compounded quarterly instead of annually?
3. Present Value & Loan Repayment
A company takes a loan of Rs. 20,00,000 at an annual interest rate of 9%, which needs to be repaid in 5 equal yearly installments.
- Find the amount of each installment using Present Value Annuity formula.
- What will be the outstanding loan amount after 3 years?
4. Comparing Investment Options (Compounded Interest)
Ajay has Rs. 2,00,000 to invest and is considering two options:
- A bank deposit that offers 7% per annum, compounded monthly for 4 years.
- A mutual fund that is expected to give an annual return of 9% (compounded annually) for 4 years.
- Which investment will yield a higher return after 4 years?
- If Ajay wants to double his money, which option will help him achieve it faster?
5. Share Valuation
XYZ Ltd. has declared a constant dividend of Rs. 5 per share. The required rate of return of investors is 10%.
- Calculate the value of the share using the Dividend Discount Model (DDM).
- What will be the share price if the dividends grow at a constant rate of 4% annually?
📢 Need Online Coaching?
Get expert-led classes for MBA, BBA, Finance, Economics, Digital Marketing, and more!
📩 Contact us to enroll and boost your learning today! 🚀