Accounts & Finance

Investment AppraisalHL Only

Learning Objectives

• Understand discounted cash flows and apply and analyse the net present value method of investment appraisal

• “Time is money”• If you could have $100,000 now in a lump sum

or $100,000 over 4 years what would you have?

• Why?

• Money received today can be invested or earn interest in the bank

Discounted cash flow

• $100 received today and put in the bank paying 5% interest will be worth $105 in one year

• Therefore the present value of getting $105 in a years time is $100.

• Discounting cash flow is therefore the reverse of adding interest. It takes away anticipated inflation or interest rates to give a true value for today.

Discounted cash flow

Discounted cash flow

• The payment today is preferred for 3 main reasons:– It can be spent immediately and the benefits of

this can be obtained immediately– It can be saved and earn interest– The cash today is certain

This is called taking the “time value of money” into consideration

Discounting, how is it done?

• The present value of a future sum of money depends on 2 factors– The higher the interest rate, the less value future

cash has in today’s money– The further into the future cash is received, the

less value it has today

These 2 variables, interest rates and time, are used to calculate discount factors.

Discounting, how is it done?

• Multiply the appropriate discount factor by the cash flow

• EG. $3000 is expected in 3 years time• Current rate of interest in 10%• Discount factor to be used is 0.75 (meaning $1

to be received in 3 years time is worth the same as 75p today)

• Discount factor is multiplied by $3000 and present value is $? $2250

Discount Factors

• These will be provided on a seperate sheet in the exam as additional material

• This looks at the present value of net cash flow over the life time of a project compared to the cost of investment

• Once again uses discounted cash flows

• NPV= Total discounted cash flow – Cost of Investment

Net Present Value

NPV• Three stages in calculating NPV:

1. Multiply discount factors by the cash flows2. Add discounted cash flows3. Subtract capital cost to give NPV

Year Cash flow Discount factors at 8%

Discounted cash flows

0 ($10 000) 1 ($10 000)

1 $5 000 0.93 $4 650

2 $4 000 0.86 $3 440

3 $3 000 0.79 $2 370

4 $2 000 0.74 $1 480

Cash flow in year 0 are never discounted as they are todays values already

• Net present values are now calculated• NPV= Total discounted cash flow – Cost of

Investment

Year Cash flow Discount factors at 8%

Discounted cash flows

0 ($10 000) 1 ($10 000)

1 $5 000 0.93 $4 650

2 $4 000 0.86 $3 440

3 $3 000 0.79 $2 370

4 $2 000 0.74 $1 480

NPV

• This result means that the project earns ______ in todays money values

• So, if the finance needed can be borrowed at an interest rate of less than 8% the investment will be profitable

• What would happen to NPV if the discount rate was raised? – this would reduce NPV as future cash flows are worth even less when they are discounted at a higher rate

$1940

NPV

• Usually businesses will chose a rate of discount that reflects the interest cost of borrowing the capital to finance the project

Evaluation of NPV

• Widely used technique of investment appraisal in industry

• But does not give an actual percentage rate of return

• Often considered together with internal rate of return percentage

Evaluation of NPV

Advantages of NPV method• Allows for effects of inflation.• Adjust future cash flows to a ‘presentvalue’.Disadvantages of NPV method• Inflation is often unpredictable.• The longer into the future we go the less reliable the discount factor

He wants it higher than 35% so he wont spend too much time losing money in a unstable economy

19.6-8.4 =11.211.2 / 6 = 1.86

1.86 / 8.4 = 0.2220.222 * 100 = 22%

11.5 – 4.4 =7.17.1 / 6 = 1.183

1.183 / 4.4 = 0.2680.268 * 100 = 26.8%