Give a thought to the number of people depositing their money with various banks across the country, and across the world. You might be wondering why and how do these financial institutions decide on their profit (or interest) rates on specific amounts. To be honest, all financial institutions are just like any other business, in dire need of profits over their cost of generating income, similar to our individual efforts.

Lenders may be anyone, including you, at any point in time. We all have a fair idea of how much it cost us to make the money that we have today, and lending it to anyone would surely not be free of cost. Money has a price that is to borne by the person using it; call it a rent if you will payable over the period that the amount is borrowed from a lender. The rate of borrowing or lending – in terms of the lender – will vary on the level of risk perceived in the borrower’s business.

In addition to the risk element attached to investments, lenders take into consideration the time value of money too; this includes the current level of inflation in the economy and the forecasted level for the period of lending, the opportunity cost of lending – i.e. the benefit that could have been earned had the money been kept in a bank or invested where the investor personally preferred, and the rate of taxation. Some financial experts suggest that the general trend of all investors, debt and equity, the final or left-over return preferred the world over is actually 10%. This assumption has been tested in various countries and has been proven to be true owing to the fact that rates vary considerably in all places. Countries with volatile economic conditions will have higher rates, such as in developing countries; whereas USA and Europe have comparatively lower rates of return. Taxes and inflation also play a major role for readjustment of all rates, which equate to the investor being satisfied in receiving an exact net 10% of his investment in his/her hand at the end of the financial year.

The general tendency to help evaluate the present value of future earnings is to use the Net Present Value (NPV) or Internal Rate of Return (IRR) method. Each has a comparative advantage over the other, although NPV has proven advantages over IRR. The NPV method finds out if an investment is worthwhile based on the required rate of return. All cash flows pertaining to the evaluation are incremental – the investment is for any expenditure that is to be incurred and not already incurred; the rate of return applied is generally the after tax rate, as the investors are interested in finding out what the net benefit of the investment is after taxation.

The value of future earnings or expenditures in present terms can be calculated as

A x (1 + r)^-n
where:
A =	the net amount invested or earned in a year during the project evaluation period
r =	the required rate of return (after tax)
n =	the number of years for which the amount is to be earned or expended

Some amounts are expended or earned at a constant rate throughout the lifetime of the project or investment, termed as annuities. The value of these annuities in present value terms can be found out as

[A x 1 - (1 + r)^-n] / r
where:
A =	the net amount earned or invested annually for the period under consideration
r =	the required rate of return (after tax)
n =	the number of years the projected earnings or investments will prolong

The IRR is used to find out the maximum cost of investment that should be considered if the project is to be indifferent, i.e. no profit no loss situation. This ideally helps companies that have both, equity and debt holders, for which the Weighted Average Cost of Capital (WACC) must be calculated to find the required rate of return by investors. But first, a rate of return must be applied to the NPV calculation to reach a negative NPV for a project, which will then assist in finding out the project’s IRR.

The IRR is found as

A + [NPVA / (NPVA + NPVB)] x (B – A)
where:
A =	the rate at which the positive NPV is achieved
B =	the rate at which the negative NPV is achieved
NPVA =	the positive NPV
NPVB =	the negative NPV (the absolute value)

Although both these methods consider the time value of money, they nevertheless fail to analyse the time period by which the investment can be recovered, that is the pay back period.

In all circumstances it is advisable to analyse the money value of investments, i.e. considering the value of money for the period of investment. The reserves you hold today is not equal to the reserve held tomorrow, although an adequate payback period is always good as the longer the project period, the riskier the investment.