The economic approach

Assessing investments: Economic approach

The economic approach

In addition to the accounting approach to assessing the financial attractiveness of an investment, there is also economic approach.

The models of the economic approach differ from their accounting counterparts in that two additional factors are included in the calculations:

the investor's time preference
the risk of the investment

These two factors are added together to form the discount rate #r#. The discount rate is used to convert all cash flows from an investment to their present value . This process is also called discounting .

We will not distinguish between the two factors: both influence #r#, but it does not matter to our models how these two factors contribute to #r#.

As discussed earlier, we also speak of the discount percentage , which is the percentage #100\cdot r\%# that belongs with the discount rate #r#.

We will give the corresponding formulas.

Discounting

To calculate the present value #PV# of a cash flow, we use the following formula:

\[\begin{array}{rcl}
PV_i & =& \dfrac{C_i}{(1+r)^i}\\
&&\phantom{xx}\color{blue}{\text{the present value of the cash flow in period }i}\\
PV& =& \displaystyle \sum_{i=0}^nPV_i\\
&&\phantom{xx}\color{blue}{\text{the present value of the entire investment}}
\end{array}\]

#C_i# is the value of the cash flow in period #i# and #r# is the discount rate applied.

This formula is no different from the present value formula we discussed earlier. The difference is that the growth rate there has been replaced by the discount rate here.