Example Of Time Value Of Money As ROI Report Essay

Summary:

This case study deals with basic understanding of time value of money and return on investment. With time the value of money also changes. Profitable companies always look for good return on investment. Return on investment is the ratio of the dividend to the amount invested. The simple underlying idea is that income should be always greater than the expenditure considerably to keep the organization running. The given case study is to illustrate a practical understanding of the compound interest and return on investment. Considering the above points illustrated, a fair estimate should be given.
In the given case study, the company has to incur a cost of 20mnUSD over the next five years, for which the loan has to be borrowed upfront. The maturity amount has to be calculated and a rough estimate has to be submitted to the client.

TIME VALUE OF MONEY:

The value of money never remains the same. With passage of time, it goes on decreasing. Hence, the money borrowed today has to be returned with an extra amount to compensate for the decrease in value. This extra amount is known as ‘interest’. There are two types of interest – simple and compound. The compound interest is comparatively more than the simple interest. The compound interest of the first year adds to the principal of the second year. The principal for the second year becomes the interest for first year added to the principal of the first and so on.

Compound Interest: It is given by the formula

Amount= P(1+R/100)N

Where,

P ---> principal borrowed
R ---->rate of interest on which amount is borrowed
N----->number of years
For the given case,
The amount matured is,
Amount=20,000,000 * (1+(10/100))5
= 20,000,000*(1+0.1)5
=20,000,000 * (1.1)5
= 20,000,000* (1.61)
=32,200,000
ie. The total cost of the project incurred by the company is: 32.2 mn USD.

ESTIMATION:

The estimate reflects the selling price. The cost price is the total cost incurred. Any service rendered deserves a profit margin. No activity can be rendered for free of cost. If the estimate is equivalent to the cost incurred, it means the service cost is nil. So, some amount has to be charged as a token of efforts put in. Moreover, a considerable time has been invested in the project. Five years is quite a long time. Focusing on one project for long time also reduces the ability to work on other projects. This factor also has to be considered. So, the desired profit should also be proportionate to the time invested. Having said this, estimate of the project, initially quoted should not be revised as this would reduce the trust of the clients. This may later adversely affect the future projects. Hence the estimate has to be reasonable to the client as well as a satisfactory sum for the company undertaking the project.
Selling Price= Cost Price + Profit
So, Estimate= Total cost incurred + desired profit
The desired profit in this case should be no less than 20% of the cost. So, our profit should be one-fifth of 32.2 mn USD.
Estimate= (120/100)*32.2
= 38.64 mn USD.

CONCLUSION:

The estimate given to the client is a vital tool in bagging the order for the company. It should be set in such a way that neither the company ends up in loss nor is the estimate exorbitant. The estimate should include a premeditated return on investment. It should include the desired profit and the costs incurred. The profit desired should also be set considering the amount of time spent in the project. More the time invested, higher is the profit percentage to be included.
The cost of the project in the above case is 32.2mn USD as the amount was borrowed in compound interest with rate of interest as 10%. Though the original cost was 20mnUSD, it amounted to 32.2mnUSD. Considering the fact that the project has been done for five years, a profit margin of 20% seems appropriate. On calculating the estimate, given the cost and margin profit, we get that, the estimate submitted should be no less than 38.64mn USD.

References:

GAO Cost Estimating and Assessment Guide, Best Practices for Developing and Managing Capital Program Costs, GAO-09-3SP, United States Government Accountability Office, March 2009
Lewin, C G (1970). "An Early Book on Compound Interest - Richard Witt's Arithmeticall Questions". Journal of the Institute of Actuaries 96 (1): 121–132.