Business math can be intriguing and we, the insecure finance knowledge-hoarders, are to be blamed! We love to see that “what the heck is an En-Pee-Vee and an I-r-rh???” question written all over your faces during conversations … a sure way to establish the finance department supremacy! No more!!! Let us start the count-down from 3 to 1 and get a grip on all the business math concepts you may need to know …
Are you smarter than a 5th Grader? Here is a secret … If you learned compound interest formula in the middle-school, you already know most of the business math!
Just for an easy grasp during our conversation below, let us agree to attach “+” sign to all inflows and “-” sign to all outflows. Also, I’ll mention all the “finance-speak” in bold italic.
Count 3: Discounting is reverse of compounding.
Compounding flows from left to right on the timeline (from the present to the future) and makes numbers grow, discounting flows from right to left (from the future to the present) and shrinks the numbers!
An investment of -$100 grows to +$121 in 2 years at a compound rate of 10% p.a. ($100 [*10% = + $10] = $110 [*10% = + $11] = $121). Thus, the value of your $100 (let’s call it the Present Value) grows to $121 in the future. Your finance colleagues read the same facts backward when they want to travel from future value (FV) to the present value (PV). They say that +$121 received after 2 years has a present value of $100 if discounted at a discount rate of 10% p.a.!
There you go … that’s all that is to the discounting (or as they say, the time value of money … how value of money changes from its future value to the present value)!
The middle-school compounding formula is: Present Value x [(1+Interest Rate)^number of periods]
The discounting formula is (you perhaps already guessed and guessed it right): Future Value / [(1+discount Rate)^number of periods]
Count 2: Now, let’s solve a riddle! Adam & Eve live in the city of Eden. Normally, an investment in the city of Eden yields 10% return per year. One day, Eve approaches Adam with a project that will pay Adam +$121 at the end of two years provided he invests -$105 today. Will Adam say “yea” or “nay”?
Unlike the (in)famous “apple” question, Adam in this case will surely should scream “No Way”! He did learn compounding from his father (Father?) and hence knows about discounting, too. The Present Value of $121 that Eve has promised to give him after 2 years is +$100 since money normally grows in the city of Eden at 10% a year. Why on the earth will Adam invest anything more than $100??? Agreeing to Eve’s proposal to invest -$105 will leave a $5 hole in Adam’s pocket! In other words falling for Eve’s proposition would generate a negative Net Present Value of $5.
When Present Value of promised cash flow(s) in future is less than your investment today, you have a negative Net Present Value. That shows that you are better off of investing your cash in the “market” rather than getting lured by any of the Eve’s propositions!
Count 1: Now let us narrate the same story with one more twist … I invest -$100 today and get $121 after two years. At what rate will I need to discount my future value of $121 to get exactly zero (0) Net Present Value? “What a dumb question”, you might be thinking! Of course, 10%!!! Well then. If you were a finance professional, you would say that the Internal Rate of Retun or IRR of the project (to invest -$100 today and get $121 after two years) is 10%.
IRR is simply the discount (or interest) rate that will equate the present value and the future value of an investment proposal.
I think, now you know enough to alert your finance colleagues to pay more attention to what you have to say and all that because you ARE smarter than a fifth grader!