Friday, November 21, 2014

What is the calculation of everything earned on an investment'?

What is the calculation of everything earned on an investment'?
Depends how you are calculating return. Typically, NPV (net present value) is the most comprehensive measure of the value of an investment, which is the sum of all discounted cash flows generated by the investment:

CF(0) + CF(1)/(1+r)1 + CF(2)/(1+r)2 + ... + CF(n)/(r+r)n

Where CF(n) is the cash flow at the end of year (or period) n, and r is the discount rate (determined by the cost of capital of the investment). Note, NPV should also take into consideration the opportunity cost of the investment (that is, any cash flow foregone by pursuing the current investment as opposed to other alternative uses of the cash). The discount rate should be a measure of the risk associated with the cash flow, and, as mentioned, the cost of capital.

IRR (internal rate of return) is another common measure of return on investments, but there are additional caveats with this analysis (it does not take into consideration the scale of the investment, and it does not work for certain sets of cash flows, such as when there are alternating positive and negative cash flow). It is usually benchmarked against some other measure, such as a hurdle rate, to determine whether an investment is profitable.

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