This is from the “Accounting Makes Cents” podcast episode #55 released on Monday, 18 December 2023.
In today’s episode, since this is our last one for the year 2023, I think we should reflect back on the major investment we made in our lives, which is studying for CIMA. We’ll have a look at various investment appraisal techniques and how we calculate the value of investments or projects before we actually make some of the biggest decisions in a company.
Investment in education is just like any other investment—it requires careful evaluation and consideration. So, what are these appraisal techniques and how can they guide us in making smarter educational investments?
To start off, let’s consider the analogy of a financial investment. When you invest your money, you expect returns, right? Similarly, when you invest time and resources in education, you expect returns in the form of knowledge, skills, and opportunities.
Jump to show notes.
Net present value.
One of the fundamental techniques in investment appraisal is the Net Present Value (NPV). In the context of education, NPV helps us assess the value of an educational pursuit by calculating the present value of its future benefits, such as increased earning potential or career opportunities, minus the costs involved.
Now, let’s break down a basic Net Present Value calculation. To calculate NPV, you’ll need three things: the initial investment (negative value), expected annual returns or benefits, and a discount rate, often your expected rate of return or cost of capital.
For instance, let’s say you’re considering a $1,000 investment in a certification course that promises an additional income of $500 annually for the next five years. Your discount rate, representing the minimum return you expect, is 8%.
First, determine the present value of each annual benefit. Using the formula: Present Value (PV) = Future Value/Discount Rate^(Period)
For each year:
– Year 1: PV = 500/(1 + 0.08)^1
– Year 2: PV = 500/(1 + 0.08)^2
– Year 3: PV = 500/(1 + 0.08)^3
– Year 4: PV = 500/(1 + 0.08)^4
– Year 5: PV = 500/(1 + 0.08)^5
Sum up these present values, and then we subtract the initial investment from the total present value of benefits to get to the net present value of the project or undertaking. A positive NPV indicates that the investment is likely to generate more returns than the initial cost, while a negative NPV implies the investment might not meet your desired returns.
While this might seem daunting at first, various online calculators and spreadsheet software can simplify this calculation. Understanding the concept behind NPV is what’s essential in making informed decisions about your educational investments.
Payback period
Another crucial technique is the Payback Period. Imagine you’re investing in a course or a degree program. The Payback Period helps determine how long it will take for the benefits (like higher salary or job advancement) to cover the initial investment (tuition fees, study materials, etc.). This technique is vital in understanding the time it’ll take to recoup your educational investment.
Calculating the Payback Period is straightforward. You’ll need the initial investment and the expected annual returns or benefits.
Consider investing $1,000 in a course that promises an additional income of $500 per year. To determine the payback period, divide the initial investment by the annual returns.
Payback Period =Initial Investment/Annual Returns
Payback Period = $1000/$500 = 2 years
This means that it would take two years to recover the initial $1,000 investment through the $500 annual returns.
The shorter the Payback Period, the quicker the investment pays for itself. However, remember that a shorter Payback Period might not always reflect the complete picture of the investment’s long-term benefits.
Internal rate of return
Lastly, let’s not forget about the Internal Rate of Return (IRR). This technique measures the potential profitability of an investment. In the context of education, IRR helps in comparing different learning options by calculating the rate at which the benefits equal the costs. Essentially, it helps you identify which educational path might yield the highest returns.
Calculating IRR can involve iterative calculations, but most software and calculators can compute it easily. However, understanding the concept is essential.
Consider a scenario where you’re comparing two educational investments. One requires an initial investment of $10,000 and promises a future value (benefit) of $15,000. The other investment requires an initial outlay of $20,000 and promises a future value of $30,000.
When the NPV is zero, that is when we determine the IRR.
Alternatively, we can also calculate the IRR manually. We’d have to start with an estimated rate, let’s say 10%, and apply it to both investments’ cash flows. Then, adjust the rate until the present value of future cash flows equals the initial investment. A lot of trial and error on that. You iterate by adjusting the IRR until the equation balances out for both investments.
However, as mentioned, most often, spreadsheet software or financial calculators handle these iterative calculations more efficiently.
Conclusion
Now, applying these techniques to educational decisions might seem complex, but it’s essential for informed choices. By using NPV, Payback Period, and IRR, you can analyze which option provides a higher return on investment based on your time frame, career goals, and financial situation.
Remember, education is an investment in yourself—a long-term strategy. While these techniques provide valuable insights, they’re not the only factors to consider. Things like personal interest, passion, and the intangible benefits of learning should also play a role in your decision-making process.
Show notes simplified
In this episode, MJ the tutor delves into the essential tools – Net Present Value, Payback Period and Internal Rate of Return – that empower you to make informed decisions in your learning journey. Learn how to measure the worth of educational pursuits, calculate returns on your investment and strategise for a smarter, more fulfilling path to knowledge.
Credits:
“Ding Ding Small Bell” (https://freesound.org/s/173932/) by JohnsonBrandEditing (https://www.youtube.com/channel/UC1RImxnsbfngagfXd_GWCDQ) licensed under CC0 Licence.
MJ THE TUTOR 