Present Values and Rate of Return - Business School Basics - Lesson 4

Learn how to calculate the rate of return and net present value (NPV) of an investment. This Business School Basics lesson explains how present value, required return, and the opportunity cost of capital connect in a worked one-year investment example. WHAT IS THE RATE OF RETURN? The rate of return measures an investment's profit as a percentage of the amount invested. For a one-year investment with a single payoff: Rate of return = (Future cash flow - Initial investment) / Initial investment × 100% WHAT IS NET PRESENT VALUE? Net present value measures the value an investment creates in today's money after accounting for the required return. For the one-year investment in this lesson: PV = Future cash flow / (1 + r) NPV = PV - Initial investment Here, r is the annual required return expressed as a decimal. WORKED EXAMPLE: NPV AND RATE OF RETURN A machine costs $2,400,000 today and pays $2,750,000 in one year. The opportunity cost of capital is 12%. 1. Calculate the profit: $2,750,000 - $2,400,000 = $350,000 2. Calculate the rate of return: $350,000 / $2,400,000 × 100% = approximately 14.6% 3. Calculate present value: $2,750,000 / 1.12 = approximately $2,455,357 4. Calculate NPV: $2,455,357 - $2,400,000 = approximately $55,357 SHOULD THE INVESTMENT BE ACCEPTED? Both methods support accepting this project. Its return of approximately 14.6% exceeds the 12% required return, and its NPV is positive. The return exceeds the hurdle rate by approximately 2.6 percentage points. The NPV expresses the value created as approximately $55,357 in today's money. NPV VS. RATE OF RETURN NPV answers: How many dollars of value does the investment create? Rate of return answers: What percentage return does it generate, and does that exceed the required return? In this one-year example, both tests lead to the same accept-or-reject decision. IN THIS LESSON, YOU WILL LEARN: How to calculate an investment's profit and percentage return. How the opportunity cost of capital sets the hurdle rate. The difference between required return and excess return. How present value connects to NPV. How to evaluate the same investment using dollars and percentages. TRY IT YOURSELF Invest $1,800,000 today and receive $2,100,000 in one year. The required return is 14%. Calculate the profit and rate of return, decide whether to accept the investment, and confirm your decision with NPV. Share your answers in the comments. Lesson 4 of Business School Basics is for business students and beginners learning corporate finance, investment appraisal, and capital budgeting. Subscribe to Business School Basics for more finance lessons. #RateOfReturn #NetPresentValue #CorporateFinance