This video is the 1st in a 4-part series that presents the essentials of investment decision-making. This series shows how to evaluate investments, particularly those associated with projects. Part 1 covers the Time Value of Money, Cash Flows, and Incremental Analysis.


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Financial Analysis using Excel - The Essentials of Investment Decision Making, this video is the first in a four part series that presents the essentials of investment decision making. Financial analysis is a broad discipline for assessing the viability and the profitability of business. This series shows how to evaluate investments, particularly those associated with projects. I hope you will find this information useful. This episode covers the Time Value of Money, Cash Flows and Incremental Analysis. What is meant by the term, Time Value of Money? Let's consider an example. What's better, $500 today or $500 two years from now? You probably would agree that receiving $500 today is superior. You are happier having money in your hands now rather than hoping to receive money sometime in the future. You also encounter the time value of money when you work with interest. Interest, of course, is the charge paid for a loan, the longer it takes you to repay a loan, the more interest you pay. Even the interest rate is higher on longer loans. Consider another example, you borrow $1000 for one year at 10% interest, the money borrowed is principal. At the end of one year you owe a $100 in interest as well as having the obligation to repay the principal of $1000. If you do not repay the principal nor the interest, and keep the money for a second year, the interest continues to accumulate on the unpaid interest as well as on the principal so that you owe $1210. This phenomenon of interest growing on itself is called compounding or compound interest. It's a snowball effect of interest. When analyzing investments you can base your analysis upon any point in time or upon a series of recurring payments. To keep this discussion as simple as possible, we will consider investments exclusively from the point of view of the present moment. Because we will translate all future income and cost to the present, this type of analysis is called present value analysis. Most investors this convention. We'll adhere to this rule, but be aware that other methods exist. Reiterating what we just considered, present value analysis converts all money into present dollars, and present dollars represent the present value of money you expect to receive in the future. Generally, the present time is the moment when an investor makes an investment decision. We call this point, time zero. Most analysts consider time zero to be of short length, such as several days or a few months. In some instances, time zero can be a full year; however, time zero never exceeds one year. It typically runs much less than a full year. Note that present value analysis brings all future money back to the present using compound interest. Investors often use the term discount rate or discount factor, but it's nothing more than compound interest. We will talk about the discount factor a bit later, but first, let's discuss another important term, cash flow. Cash flow is the movement of money in and out of a business or an account, examples include, personal checking account, the company's cash flow statement, the tabulation of a project's cost and revenues, business analysts call the cash generated by a company, the operating cash flow. It's the firm's net earnings tallied after the company, pays taxes and adds back in depreciation. Business people also talk about other types of cash flows such as the cash flow from assets, the cash flow to creditors and the cash flow to stock holders. But we will not concern ourselves with these, just be aware they exist. We will focus on project cash flows. A project cash flow is a series of values that reflects the investment used to initiate a project and the net revenue stream generated by the investment. Mathematically, the net cash flow for each period of time, generally lasting one year, consists of revenue or savings minus production cost, minus taxes, minus capital. Please note that production cost includes both operating and repair cost. To help us understand how money flows in and out of a project, we show money, we gain as positive numbers and money we disperse is negative numbers. Capital is the money spent at the beginning of a project to buy or build an asset which later generates revenue or savings. In the bar chart shown here, the two bars with negative numbers represent the investment made at time zero and year one and the subsequent bars and positive numbers in years 2-5 reflect income. The last concept we need to consider to set the stage is incremental analysis. Many investments represent small portions of large businesses. As an investor, business owner, engineer, manager or analyst, you need to understand the incremental revenue generated from each incremental investment. As you focus on incremental inputs and outputs, you place yourself in the position to understand and to control investment capital, so as to ensure that each dollar works for you or for your organization. This enables you to avoid lumping non-essential work with profit-making elements. Failing to approach investments from an incremental point of view can easily result in goal planning and waste. To recap, the time value of money look at the timing of investments and income. Money received sooner is more important than equal money received in the future. The cash flow is a series of negative and positive values reflecting how money flows from and to an investor. Investors must look incremental cash flows. The next three videos will cover the financial tools used to evaluate investments and the application of those tools to investment decision making. For more information on this topic, visit us at ToweringSkills.com. If you have specific questions relating to financial analysis or project management, you can post your queries on our forum, also at Towering Skills.