Investment appraisal is one area of the study of finance that has a lot of misunderstood terms. Here are 22 of those terms and there meaning in common language that can be understood by everyone.
The terms to be explained are listed below followed by brief explanation of the term
IRR; IRR stands for Internal Rate of return. It is the rate at which investment equals cash inflows. It is calculated based on trial and error or interpolated after at least two trials.
NPV; NPV stands for Net Present Value. This is a term used to describe the difference between a project’s entire cash flow discounted to today’s value less the initial investment at today’s cost.
ROCE; This simply means return on capital employed. It can be calculated in various ways but the most popular one is based on average profit/average investment.
Present value. This is the cash equivalent now of the sum of money receivable or payable at a stated future date, discounted (stated in today’s term) at a specific rate of return.
Time value of money. One Naira today is definitely not the same one Naira that will be received in one year’s time.
Future value; the is the predicted value of one Naira that we have today. You calculate it using this formula FV= PV (1=r)n where r is the discount rate and n is the number of period
Discount rate; this is the rate that is used to calculate a projects present value. In other words, it is the cost of capital put differently.
Cost of capital/ target rate of return. This in common parlance is what the providers of fund expect you to give to them as compensation for their risk.
Discount factor; this is the figure that is used to bring an amount to today’s term.
Compounding; this simply means adding the interest from previous years to the capital in this year and recalculating the interest. This will obviously give a higher interest.
Discounting; Discounting is an attempt to get the today’s value of an expected future cash flow.
Simple Interest; This is interest that is based only on the capital (initial/ given amount) year-in-year-out.
Compound interest; This is the interest calculated on compounding basis. It is the direct opposite of the simple interest.
Cash flows. This is the inflow or outflow of monetary resources that our business experiences as a result of our investment decisions.
Sensitivity analysis; this is a term used to describe one of the methods of measuring risk. It measures the volatility of NPV to other variables.
Profitability index. It is used to make investment decision in time where there is capital rationing.
Uncertainty; This is the term used to describe a situation where decisions are made without reference to past record. The outcome of the investment is known and cannot be predicted from past record.
Risk. This is when the outcome of an investment is not known but can be reasonably predicted based on past records.
Project specific rate. This is the rate that is used to evaluate a project that has different characteristic from the company as a whole.
CAPM; this is a method of calculating the cost of capital. It is an attempt to correct the weakness of dividend growth valuation model, risk factors are included into the calculation.
Relevant cash flows. these are cash flows that will be incurred or avoided as a result of either taking up an investment opportunity or not.
Beta. This is a tool used to measure the risk factor of a stock/ project in relation the overall prevailing situation. If for example a stock has a beta of 1.5, any movement in the market will be magnified by 1.5