Type: Management
Pages: 2 | Words: 333
Reading Time: 2 Minutes

This paper considers the issue of compounding in financial analysis in regards to how the Net Present Value is calculated and the significance of the indicator. In financial management, money is earned while some is spent. To make sense of such cash flows, one needs to pay attention to comparable terms by taking into account the Time Value of Money concept. This is because a pound earned today is worthy more than a pound earned a year from now. This reasoning is informed by the fact that during the year-end long, there are matters that arise which lower the value of a future pound. For instance, inflation, interest rates, and the cost of postponing consumption today for a future consumption contribute to the declining of the worth of money.

Compounding is converting a present sum or cash flow into a future sum. This helps to form a picture of what the worth of the current sum of money or investment would be in the future. This is used to draw a meaningful conclusion since a clear picture of the future is given through converting of some current amounts into future sums (Nitzan, 2009). The Net Present Value represents the current worth of some interest. This is done by computing the present values of all the incomes, less the present value of all the expenses. By arriving at such a figure, this would represent the Net Present Value of interest. To get the present value, reducing the future incomes or expenses, majorly cash flows or lump sum, into present values by use of appropriate interest rates is done.

The Net Present Value is an important indicator of the worth of an undertaking or project. Projects with higher Net Present Values are preferred to those with lower values. It is therefore a guide to investors on how they can invest their money for an appropriate return. For instance, projects with negative NPVs means that there is no worthy return for such an investment and should be declined.

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