MONEY 21 - INTEREST CALCULATIONS

THIS IS MY 21^ST POST ON UNDERSTANDING MONEY TOOLS

Money, Money, Money. A friend from Flagstaff, AZ, recently asked me to post a tutorial on various types of interest and returns on investment, so here goes. Even though he is an accomplished businessman he told me he lacks knowledge in this area.  We will cover only a couple types and give simple examples.

Simple Interest: What is my return on investment over a one year time period assuming I can have the total return of my capital investment back?  So you loan me $100 for exactly one year, and I give you $105 back what is your return as measured in “simple interest” terms? 5%.  I determined this by calculating the difference between $100 and $105 which is $5.  Then, take the original capital amount, or principal amount, $100, and divide it into $5. The result is .05. To make .05 a percentage move the decimal point two places to the right….5%.  For us lesser brained individuals it helps to remember to divide the larger number into the smaller number!

Compound Interest: You can figure this amount with a calculator that has the symbol for compound interest, or do it on paper like we will here. Let’s assume we have $100 again and you lend it to me for a three year period again at 5%. How much will I return to you after three years? 

Year one: $100 X 5% equals $5, then add that on the next year’s principal.

Year two: $105 X 5% equals $5.25. Now, I owe you $110.25 the end of year two. Add that onto your principal.

Year three: $110.25 X 5% equals $5.52 (rounded up to the next penny).  Therefore, at the end of year three I will pay you $115.77 for the money I borrowed for three years.  The interest for each year is calculated on the principal amount adding in each prior year’s interest, thus the term compounding of interest.

Rate of Return (ROR):  We covered this in a real estate blog, but let’s go over it again. This is similar to simple interest. Let’s say we invest or buy something for $100 and sell it one year later for $105.  $105 minus $100 is $5.  The original principal or invested amount $100 divided into $5 is .05.  Again, the larger number into the smaller number!  Move the decimal point two places to the right and you have 5%.  Conversely, to work mathematically from a percentage move the decimal point two places to the left, thus back to .05.

Internal Rate of Return (IRR):  This is a bit tricky, but is commonly used in investments such as oil and gas and real estate.  Oil and gas wells are depleting assets, and hopefully the other, real estate, is an appreciating asset. This takes into consideration a different ending principal amount, or a principal/invested amount, that may differ from the original (the effective rate of return).  It is used in capital budgeting and analyzing investments.  It can also be referred to as “discounted cash flow”.  In oil and gas, wells are a depleting commodity, therefore are worth less over a given period of time or perhaps not worth anything at the end of a period of time. This needs to be factored into your investment decision and return on investment.  In theory let’s assume you and others invest $100 each in a partnership for oil and gas drilling. The well may produce a return of 50% the first year, 30% the second year and 25% the third year, and on and on for a few years until the well is depleted or waters out.  At that time, excluding equipment, the well is essentially worthless and you need to figure out over a period of time what your returns are.

Another case for IRR is real estate.  Real estate is made up of commodities, like materials that can fluctuate and many times go up in value over time. In this circumstance, let’s say we take our $100 and invest in a real estate partnership (perhaps a REIT on the New York Stock Exchange). The partnership may pay out 6% the first year, 5% the second year and 8% the third year.  At the end of 3 years the partnership, or your interest in it, is sold for $112 because of appreciation in value of the asset or assets.  Now, you need to figure out the internal rate of your return.  The formula is fairly complex and we won’t cover this, but this is the theory.

In the next blog we will continue from here on this topic into annual percentage rates, present values and future values of money.