on 08-Jul-2017 (Sat)

Another perspective on value creation comes from converting the initial investment into a capital charge against the annual operating cash flows that the project generates. Recall that the project generates an annual operating cash flow of ¥294,800,000. If we subtract a capital charge of ¥270,570,310 (the amount of a five-year annuity having a present value of ¥1,000 million at 11 percent), we find ¥294,800,000 − ¥270,570,310 = ¥24,229,690. The amount of ¥24,229,690 represents the profit in each of the next five years after taking into account opportunity costs. The present value of a five-year annuity of ¥24,229,690 at an 11 percent cost of capital is exactly what we calculated as the project’s NPV: ¥89.55 million. Therefore, we can also calculate NPV by converting the initial investment to an annual capital charge against cash flow.

The money-weighted rate of return has a serious drawback. Generally, clients determine when money is given to the investment manager and those decisions may significantly influence the money-weighted rate of return. A general principle of evaluation, however, is that a person or entity should be judged only on the basis of their own actions, or actions under their control. An evaluation tool should isolate the effects of the investment manager’s actions.

The Rule of 72 is loosely based on the observation that it takes 12 years to double an amount at a 6 percent interest rate, giving 6 × 12 = 72. At a 3 percent rate, one would guess it would take twice as many years, 3 × 24 = 72.