Tuesday, 7 October 2014

Interpolation Formula Used in Financial Management

The interpolation formula which I am going to share with you today is considered
as cumbersome formula by majority of the students because most of the times the student fails to understand it. As personally happened with me also, but being consistent and determined with your target, you can surely achieve it, so here I will provide some information about Interpolation Formula used in financial management's Capital Budgeting (Investment Decisions).

We know that using interpolation formula we have to calculate  Discount (interest) rate/Internal rate of return which is between two individual rates in the present value interest factor table. When you reach the two discount rates, where one gives a positive Net Present value and another gives a negative one you can apply the following formula to get the accurate IRR.

IRR = Lower rate + {(NPV1 x Differece between the rates used)/  (Present value of Net Cash Flows by lower rate  -     Present value of Net Cash Flows by higher rate)}

Interpolation Formula (Lmeasy.blogspot.com)
Example:- If during our trail and error process we reach two rates i.e., 10% as a Positive NPV rate and 11% as Negative NPV rate then we can calculate IRR as:
10 + {(NPV by 10% x 1)/  (Present value of Net Cash Flows by 10% (-minus) Present value of Net Cash Flows by 11%)}

Note: Students should appreciate the difference between NPV and Present value of Net Cash Flows.
While Present value of Net Cash Flows is the sum of Present value of cash flows during the life of project. NPV is Present value of Net Cash Flows (-minus) Initial Investment/Discount total outflow.

Note: In the above formula NPV by Lower rate is multiplied by 1, which solely depends upon the rates used to locate IRR. For Instance if in place of 11% there was 15% then NPV by Lower rate will be multiplied by 5 (i.e., the difference between the two rates)

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