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Evaluating Flows of Money - Coggle Diagram
Evaluating Flows of Money
time preference problem
reflects the current relative valuation placed on receiving a good or sum of money at an earlier date compared to receiving it at a later date
eg 100 pounds now or in 10 years
sequence of cash flows
helps understand projects or activities from a financial perspective
Need Metrics
to compare flows
incremental cash flow in
: the additional or new cash inflow generated because of the project.
cumulative cash flow out
: total cash spent on the project up to a certain point in time
interest rate and discount rate
interest rate
amount of money (interest) due per period of time where a sum of money (principal sum) is lent, borrowed or deposited
compound interest
: future interest on principal sum and and all previously accumulated interest (gov bonds don't have this)
discount rate
reflects the return that could be obtained per unit time, normally per year, on an investment with equal risk. It is the conceptual reverse of interest rate
minimum acceptable rate of return (MARR)
investment must
at least be at or above current interest rate
provide an incentive to do more than put cash in a savings account
recognise risk
must consider
current available interest rate
current inflation level
allowance for risk
some increment above the basic risk-free interest rate to encourage investors
disadvantages
MARR sets r as an arbitrary parameter (also somewhat a strength, analyst can build in other aspects such as risk and possibly personal interest)
internal rate of return
forms approach to the evaluation of cash flows that avoids setting an arbitrary rate of return, logic close to MARR
requires cumulative NPV of a project to be 0 at the end
find IRR based on requirement
at IRR, discounted investments (negative cash flows) are equal to the sum of discounted returns (positive cash flows). Basically, at IRR the outgoing and incoming cash flows of the project are in balance, subject to discounting
choose project
with highest IRR as a measure of profitability
equates to the interest received annually on a fixed income investment (bond) which is the equivalent to the investment
interest paid out annually so no compounding
overall specification of an equivalent bond can be established, useful for
comparisons against alternative investments
cost of negative cash flow
company needs to borrow or seek investment to fund a new project
company has to use cash that could be invested in some other way
need to ensure project is
viable
return on money invested
return on the cost of investment
additional true earnings
project also needs to compete w other projects
investment
owners capital
(equity)
share value of a company, might include option to bring new investors as owners (sell part of the company)
reserve capital
(retained profit)
belongs to owner's but retained for reinvestment rather than dividends
loan
(debt)
raised from banks (example), all involve an obligation to pay interest during the term of the loan and the capital at the end
all have opportunity cost
either in interest or by the loss of income from another investment