Basics of Financial Arithmetic

How to measure performance of an

investment
Rate of interest
- Simple interest
- Compound Interest

Return on Investment (ROI)

There are some techniques those use the concept of time

value of money as a decision making tool -
Net Present Value (NPV)
Internal Rate of Return (IRR)
Calculation of Simple interest ( SI)

SI = Principal X (rate of interest/100)X (time in number of

years)
Therefore, the Final Amount = Principal { 1+(r*t/100)}

Problem : Rs. 1000 is invested at simple interest of 8% per

annum. How much will you receive after 10 years ?
Calculation of Simple interest ( SI)

SI = Principal X (rate of interest/100)X (time in number of

years)
Therefore, the Final Amount = Principal { 1+(r*t/100)}

Example : Rs. 1000 is invested at simple interest of 8% per

annum. How much will you receive after 10 years ?
Answer:
A = 1000{1+{8*10/100)} = 1800
 Compound Interest (CI)
In simple interest, the Principal only earns the interest whereas in
Compound Interest, the interest paid for the first period is added to the
principal and the sum of principal and interest earns interest for the next
period. It continues till the last period….
Interest is paid on interest
Reinvestment of interest rather than paying out the interest.
Compounding or the reinvestment has tremendous power of magnification.
Problem : A lends Rs. 1000 to B and charges interest at the rate of 8% per
annum compounded annually. How much B will return to A after 10 years
to repay the loan?
Accumulated Amount (A)= Principal ( 1+ r/100)^t, where r= ROI and t=time
in years.
 Compound Interest (CI)
Problem: A lends Rs. 1000 to B and charges interest at the rate of 8% per
annum compounded annually. How much B will return to A after 10 years
to repay the loan?
Accumulated Amount (A)= Principal ( 1+ r/100)^t, where r= ROI and t=time
in years.
A = 1000(1 + 8/100)^10 = 2158.92
Frequency of compounding is important in CI
In the previous example let us assume that the interest is
compounded quarterly instead of annual compounding i.e. in
every quarter 8/4 = 2% interest is added to the principal and
this sum of principal plus interest earns interest for the next
period.
In this case,
Accumulated Amount (A) = Principal {1+ r/(n*100)}^nt ,
where n= compounding frequency
Solve the previous problem with interest paid at quarterly
intervals.
Frequency of compounding is important in CI
Solution :
Accumulated Amount (A) = Principal {1+ r/(n*100)}^nt ,
where n= compounding frequency
In every quarter 8/4 = 2% interest is added to the principal
and this sum of principal plus interest earns interest for the
next period.
In this problem, n=4 ( quarterly means 4 times in a year)
Therefore, n*t = 4*10 = 40 and r/n = 8/4 = 2 %
A= 1000{1+2/100}^40 = 2208.04
Revisit the earlier example :A lends Rs. 1000 to B and charges interest at the rate of 8% per
annum How much B will return to A after 10 years to repay the loan? ( for both the
cases where interest is charged simple and compounded quarterly)
Let us consider the repayment period of 20 years in stead of 10 years in the above
example.

Accumulated amount increases faster with increase in the period of

reinvestment :
Problem : Calculate the accumulated amount in the above example – for
20 years and compare with that after 10 years.

With Simple Interest

With Compound Interest (quarterly compounding)
Solution :
Accumulated Amount ( in Rs.) in the above example – for different
periods -

With Simple Interest

With Compound Interest (quarterly compounding)
 Return on Investment (ROI)
- Return on Investment (ROI) is the increase or decrease in the value of
an investment over the period under consideration in percentage.
How to get ROI ? Calculate the difference between the expected value or
actual value at the end of the period and the original value, divide by the
original value and then multiply by 100.
Example : 5 years ago ‘A’ made an investment of Rs. 10,000 and its
present value is Rs. 15,000. Calculate the ROI.
ROI = [(15,000 – 10,000)/10,000] X 100.
The ROI is 50%.
Simple interest yield per year = ROI/T , where T is the period of
investment in years.
So, in the above problem it is 50/5 = 10% per year
Net Present Value (NPV)
This technique uses the concept of time value of cash flow.
Money that you have today is more valuable than an equal
amount of money after 10 years. It is important to evaluate
how much that money is worth today.
- To calculate NPV of a project, discount each cash flow with
the desired discount rate keeping in view the time lapse.
PV = Cash flow/(1+r/100)^T , where T is the time in years
and r is the discount rate.
Therefore, NPV = summation of cash flow of all the years
after converting to PV.
 Example : Cash flow for a project is given in the
table. Find the NPV at 10% discount rate.

Period
At
Period
present
Cash flow ( Rs.) Cash flow
-10,00,000
( Rs.)
Year 1 1,00,000
Year 2 2,00,000
Year 3 3,00,000
Year 4 5,00,000
Year 5 5,00,000
Total cash flow between Year 1 and Year 5 16,00,000
Solution of the problem :
Period
Period Cash flow ( Discount rate NPV ( Rs.)
Cash flow ( Rs.) Rs.) (%)
Now - 1000000 10 -10,00,000
Year 1 100000 10 90,909
Year 2 200000 10 1,65,289
Year 3 300000 10 2,25,394
Year 4 500000 10 3,41,507
Year 5 500000 10 3,10,461

Total Cash flow from Year 1 to Year 5 = Rs. 16,00,000

NPV of the cash flow from Year 1 to 5 = Rs. 11,33,560
 Internal Rate of Return (IRR) pg1/2
Uses the concept of time value of cash flow for decision making.
If a discount rate can be determined such that the sum of present value
of all the future cash flows equal the initial investment, this discount rate
is called the Internal Rate of Return ( IRR). Therefore, the NPV of the cash
flow of the project is zero at the underlying rate termed as IRR.
How to calculate the IRR –
Put NPV = 0 and find out the discount rate.
-IRR can easily be calculated using Excel by using the function

=IRR(Xn1:Xn2)
Cont’d..
 Internal Rate of Return (IRR) pg2/2

- In Excel ‘MIRR’ function returns the modified internal rate of

return (MIRR) for a series of cash flows, taking into account both
discount rate and reinvestment rate for future cash flows.
=MIRR (values, discount rate, reinvestment rate)
Reinvestment rate is the interest rate received on cash flows on
reinvestment.
 Example : Let us find out the IRR of the
following cash flow:
Today -10,00,000
Year 1 1,00,000
Year 2 2,00,000
Year 3 3,00,000
Year 4 5,00,000
Year 5 5,00,000
Total cash flow between Year 1 and Year 16,00,000
5
 Solution of the problem :

Amount ( Discount Discounted Discounted Cash

Period Rs.) rate Cash flow Discount rate flow
Today -10,00,000 10% -10,00,000 13.99% -10,00,000
Yr1 100000 10% 90909 13.99% 87724
Yr2 200000 10% 165289 13.99% 153909
Yr3 300000 10% 225394 13.99% 202521
Yr4 500000 10% 341507 13.99% 296098
Yr5 500000 10% 310461 13.99% 259748
Total
from
Yr1to 5 1600000 1133560 1000000
IRR 13.99%
 Future Value (FV)
In arriving at the Future value of money we use the concept of NPV.
In NPV we discount the future cash flow to find out how much that
money is today.
In future value we calculate the value at a later date of an amount of
money we have today.
Inflation is a factor that reduces value of money over a period of time.
PV = Cash flow/(1+r/100)^T , where T is the time in years and r is the
discount rate.
FV = PV (1+r/100)^T , FV = Future Value, PV= Present Value, r= rate of
inflation and T is the time period in years.
 Problem on Future Value (FV)
X spend Rs. 50,000 per month. After 30 years how much will be
required by her per month to maintain the same standard. Consider
annual inflation rate at 7% .
Solution :
FV = PV (1+r/100)^T
= 50000 * (1+7/100)^30 = 50000*(1.07)^30 =50000*7.61224=3,80,612
Thank You