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 £300,000 | Project B - investment £300,000 | |
|---|---|---|
| Cash flow | Cash flow | |
| Year 1 | 130,000 | 120,000 |
| Year 2 | 110,000 | 100,000 |
| Year 3 | 90,000 | 80,000 |
| Year 4 | 80,000 | 70,000 |
Net Present Value
| Discount Rate | |||||||
|---|---|---|---|---|---|---|---|
| Year | 2% | 4% | 5% | 6% | 8% | 10% | 20% |
| 1 | 0.98 | 0.9615 | 0.952 | 0.9434 | 0.9259 | 0.9091 | 0.8333 |
| 2 | 0.961 | 0.9246 | 0.907 | 0.89 | 0.8573 | 0.8264 | 0.6944 |
| 3 | 0.942 | 0.889 | 0.864 | 0.8396 | 0.7938 | 0.7513 | 0.5787 |
| 4 | 0.924 | 0.8548 | 0.823 | 0.7921 | 0.735 | 0.683 | 0.4823 |
| 5 | 0.906 | 0.8219 | 0.784 | 0.7473 | 0.6806 | 0.6209 | 0.4019 |
| 6 | 0.888 | 0.7903 | 0.746 | 0.795 | 0.6302 | 0.5645 | 0.3349 |
| 7 | 0.871 | 0.7599 | 0.711 | 0.6651 | 0.5835 | 0.5132 | 0.2791 |
| 8 | 0.853 | 0.7307 | 0.677 | 0.6271 | 0.5403 | 0.4665 | 0.2326 |
| 9 | 0.837 | 0.7026 | 0.645 | 0.5919 | 0.5002 | 0.4241 | 0.1938 |
| 10 | 0.82 | 0.6756 | 0.614 | 0.5584 | 0.4632 | 0.3855 | 0.1615 |
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 | |||
|---|---|---|---|
| Year | Extract from discount tables at 4% interest | Expected net cash flows | Present value |
| Year 1 | 0.9615 | 130,000 | 124,995 |
| Year 2 | 0.9246 | 110,000 | 101,706 |
| Year 3 | 0.889 | 90,000 | 80,010 |
| Year 4 | 0.8548 | 80,000 | 68,384 |
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.