There are a few key financial calculations that you must be able to practically apply and understand.
These calculations include the following:
- Return on Investment (ROI): This is expressed as a percentage of the net benefits divided by the cost of the change. The formula to calculate ROI is as follows:
ROI = (Total Benefits - Cost of Investment)/Cost of Investment) x 100
An example is as follows:
ROI = ($300,000 - $200,00)/($200,000) X 100 = 50%
- Discount rate: This is the assumed interest rate used in present value calculations. This value is determined by the organization and made available for any Present Value (PV) calculations.
- PV: This calculates the present-day value of the expected benefits. PV is expressed in currency format and doesn't take the cost of the investment into account. The formula to calculate PV is as follows:
Present Value = Sum of (Net benefits in that period / (1 + Discount rate for that period)) for all periods in the cost-benefit analysis.
An example is as follows:
| Net benefits | Discount rate | Period |
| $50,000 | 1% | Year 1 |
| $40,000 | 1.3% | Year 2 |
| $35,000 | 1.5% | Year 3 |
PV = ($50,000/(1+1%))+($40,000/(1+1.3%))+($35,000/1+1.5%)
= $49,504.95 + $39,486.67 + $34,482.76 = $123,474.38 = PV
- Net Present Value (NPV): NPV is the PV value minus the cost of the original investment. The formula to calculate NPV is as follows:
NPV = PV - Cost of investment
Let's see an example. Assume a cost of investment of $50,000 and the PV from the previous example:
NPV = $123,474.38 - $50,000 = $73,474.38
- Internal Rate of Return (IRR): This is the interest rate that an investment breaks even at. This assists us in determining whether an investment is worth investing in and can be used to compare different solutions. The formula to calculate the IRR is as follows:
NPV = (-1 x Original investment) + Sum of (Net benefit for that period / (1 + IRR) for all periods) = 0
The IRR calculation is complex and is often calculated in different ways. It is the value that will make the NPV zero in the preceding equation.
- Payback period: The payback period provides a projection on the time period that is required to generate enough benefit to recover the original cost of the change, irrespective of the discount rate. There is no standard formula for the payback period and it is expressed in years when calculated.