Essential Finance Formulas
Understanding fundamental finance formulas is crucial for making informed financial decisions, whether you’re managing personal finances or analyzing business investments. Here are some key formulas explained:
Simple Interest
Simple interest is calculated only on the principal amount. The formula is:
Interest = Principal x Rate x Time (I = PRT)
Where:
- Principal (P) is the initial amount of money.
- Rate (R) is the annual interest rate (expressed as a decimal).
- Time (T) is the duration of the investment or loan in years.
For example, if you invest $1,000 at a 5% simple interest rate for 3 years, the interest earned would be $1,000 x 0.05 x 3 = $150.
Compound Interest
Compound interest is calculated on the principal amount and the accumulated interest from previous periods. It’s often more beneficial than simple interest over longer periods.
Future Value = Principal x (1 + Rate)Time (FV = P(1 + r)n)
Where:
- Principal (P) is the initial amount of money.
- Rate (r) is the annual interest rate (expressed as a decimal).
- Time (n) is the number of compounding periods (usually years).
If you invest $1,000 at a 5% compound interest rate for 3 years, the future value would be $1,000 x (1 + 0.05)3 = $1,157.63.
Present Value
Present value (PV) is the current worth of a future sum of money, discounted at a specific rate of return. It helps determine how much a future payment is worth today.
Present Value = Future Value / (1 + Rate)Time (PV = FV / (1 + r)n)
Where:
- Future Value (FV) is the amount of money you expect to receive in the future.
- Rate (r) is the discount rate (expressed as a decimal).
- Time (n) is the number of periods until you receive the future value.
If you expect to receive $1,000 in 3 years, and the discount rate is 5%, the present value is $1,000 / (1 + 0.05)3 = $863.84.
Rule of 72
The Rule of 72 is a simple way to estimate how long it will take for an investment to double at a given interest rate.
Years to Double = 72 / Interest Rate
For example, if you have an investment earning 8% interest, it will take approximately 72 / 8 = 9 years to double.
Net Present Value (NPV)
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
NPV = ∑ (Cash Flowt / (1 + Discount Rate)t) – Initial Investment
Where:
- Cash Flowt is the cash flow during period t
- Discount Rate is the rate used to discount future cash flows back to their present value
- t is the time period
A positive NPV suggests the investment is profitable, while a negative NPV suggests it’s not.
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