Essential Financial Concepts
Master the fundamental financial calculations that drive investment decisions, from compound interest to discounted cash flow analysis.
Time Value of Money
The time value of money (TVM) is the concept that money available today is worth more than the same amount in the future, due to its potential earning capacity.
Core Principle
$1 today is worth more than $1 tomorrow
This is because money can be invested to earn interest, meaning any amount of money is worth more the sooner it is received.
Earning Potential
Money can be invested to generate returns
Inflation
Purchasing power decreases over time
Risk
Future payments carry uncertainty
Compound Interest
Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods. It's often called "interest on interest."
Compound Interest Formula
Example Calculation
Problem: You invest $10,000 at 8% annual interest, compounded monthly, for 10 years. What's the final value?
You earned $12,196.40 in interest—more than your initial investment!
Simple vs Compound Interest Growth
After 10 years at 8%, compound interest generates $4,196 more than simple interest.
Present Value
Present Value (PV) is the current worth of a future sum of money, given a specified rate of return. It answers: "What is $X in the future worth today?"
Present Value Formula
Example
Problem: What is $100,000 received in 5 years worth today, assuming a 10% discount rate?
Discounted Cash Flow (DCF)
DCF analysis is a valuation method that estimates the value of an investment based on its expected future cash flows. It's widely used to evaluate stocks, projects, and business acquisitions.
How DCF Works
- Project future cash flows for each period
- Determine an appropriate discount rate (WACC)
- Calculate present value of each cash flow
- Sum all present values to get total value
DCF Formula
Example: 5-Year DCF Analysis
| Year | Cash Flow | Discount Factor (10%) | Present Value |
|---|---|---|---|
| 1 | $10,000 | 0.909 | $9,090 |
| 2 | $12,000 | 0.826 | $9,912 |
| 3 | $15,000 | 0.751 | $11,265 |
| 4 | $18,000 | 0.683 | $12,294 |
| 5 | $20,000 | 0.621 | $12,420 |
| Total DCF Value | $54,981 | ||
Net Present Value (NPV)
NPV is the difference between the present value of cash inflows and outflows. It's used to analyze the profitability of an investment.
NPV Formula
NPV Decision Rule
NPV > 0
Accept the project. It adds value and generates returns above the required rate.
NPV = 0
Indifferent. Project returns exactly the required rate of return.
NPV < 0
Reject the project. It destroys value and fails to meet required returns.
Internal Rate of Return (IRR)
IRR is the discount rate that makes the NPV of all cash flows equal to zero. It represents the expected annual rate of return of an investment.
Understanding IRR
IRR is the "break-even" discount rate. If your required return is lower than the IRR, the investment is profitable.
IRR Decision Rule
Key Takeaways
- TVM is fundamental—always consider when money is received
- Compound interest grows exponentially over time
- DCF is essential for valuing investments and businesses
- Use NPV for go/no-go decisions on projects
- IRR gives you the expected rate of return
- Higher discount rates = lower present values
Calculate It Yourself
Use our interactive financial calculators to run your own scenarios!