C4 Investment Appraisal

Investment Appraisal is the process of assessing the viability of a project over its lifespan. Managers use investment appraisal to make decisions between different investments. Examples of investment appraisal techniques include;

  • Net present value

  • Discounted cash flow

  • Internal rates of return

Project A - investment £300,000Project B - investment £300,000
Cash flowCash flow
Year 1130,000120,000
Year 2110,000100,000
Year 390,00080,000
Year 480,00070,000

Net Present Value

Discount Rate
Year2%4%5%6%8%10%20%
10.980.96150.9520.94340.92590.90910.8333
20.9610.92460.9070.890.85730.82640.6944
30.9420.8890.8640.83960.79380.75130.5787
40.9240.85480.8230.79210.7350.6830.4823
50.9060.82190.7840.74730.68060.62090.4019
60.8880.79030.7460.7950.63020.56450.3349
70.8710.75990.7110.66510.58350.51320.2791
80.8530.73070.6770.62710.54030.46650.2326
90.8370.70260.6450.59190.50020.42410.1938
100.820.67560.6140.55840.46320.38550.1615

Net present value takes into account the fact that the value of money received in the future is worth less than if it was received today. This is because it could be invested to gain value and because inflation decreases the value of money over time. When calculating the current value of money received in the future, you can multiple by the discount factor which is predicted based on interest rates (see table).

E.g. If you expected to have cash flow of $1000 in 5 years time and the discount rate is predicted to be 5%, you would multiply $1000 by 0.784. This means that $1000 received in 5 years time is worth $784 in today’s money.

Discounted Cash Flow

Discounted cash flow is a method that can be used to assess the viability of a project based on the current value the future cashflows received as a result of the project.

Future cash flows are multiplied by the discount factor to determine the present value of the money received. The initial cost of the project is then subtracted. If this value is negative, this would not be seen as a viable investment.

Investment Appraisal on £300,000
YearExtract from discount tables at 4% interestExpected net cash flowsPresent value
Year 10.9615130,000124,995
Year 20.9246110,000101,706
Year 30.88990,00080,010
Year 40.854880,00068,384

Internal rates of Return

Internal rates of return (IRR) are the discount factors that make the overall net present value of a project zero. When looking at a project, managers may calculate the IRR to assess the value of the project. The higher the IRR, the more desirable the project is as an investment.

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Unit 7C Glossary