B5 Investment Appraisal
The net present value is the current value of future inflows and outflows of investment projects. As predictions on future returns is a major consideration in business decision making, it is important for managers to consider the time value of the money involved.
The time value of money is the principle that money you have today is worth more than the same amount in the future. This is because money today can be invested to gain returns or interest and the value of money decreases over time due to inflation. It is important to consider the time value of money during project planning because the cost is paid with today’s money but returns are from future money which is worth less.
For example, the average house price in the UK in 1993 was £120,000 compared to £260,000 in 2023 demonstrating that each £1 could buy more in 1993 and therefore had more value.
| Table of Discount Factors | |||||||
|---|---|---|---|---|---|---|---|
| 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 |
Discounted Cash Flow
Discount factors are percentages that are applied to future cash inflows in order to establish their value in the present day. Managers will decide on a discount rate based on a range of factors including market conditions, other investment opportunities and inflation. The present value of an inflow is calculated by multiplying it against the discount factor figure for the chosen percentage for the year it is expected to be received.
For example, 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 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.
To calculate the net present value of a project, the initial cost of the investment needs to be subtracted from the discounted cash flows.
NPV = discounted cash flows - initial cost of investment
If NPV is negative, this would not be seen as a viable investment.
| Investment Appraisal on £300,000 | |||
|---|---|---|---|
| Year | Extract from discount tables at 4% | 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 |
E.g. NPV = (124,995 + 101,706 + 80,010 + 68,385) - 300,000 = 796,096
Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount factor that makes the discounted cash flow of a project zero. This means that the project breaks even (all costs are covered by revenue but no profit is made).
Knowing the IRR of a project helps managers to assess its viability before going ahead with the investment.
Where the discount factor for a project to break even is viewed as unachievable, the project may be viewed as undesirable.
When deciding between different investment opportunities, projects with higher IRRs indicate more desirable investments as they generate higher returns.
| Expected Cash Flows | ||||||
|---|---|---|---|---|---|---|
| Raw data | At 2% | At 4% | At 6% | At 8% | At 10% | |
| Year 0 (investment) | (500,000) | (500,000) | (500,000) | (500,000) | (500,000) | (500,000) |
| Year 1 | 207,000 | 202,860 | 195,050 | 184,010 | 170,375 | 154,888 |
| Year 2 | 143,500 | 137,904 | 127,506 | 113,480 | 97,286 | 80,397 |
| Year 3 | 126,000 | 118,692 | 105,517 | 88,592 | 70,325 | 52,835 |
| Year 4 | 107,300 | 99,145 | 84,749 | 67,130 | 49,341 | 33,700 |
| Year 5 | 84,080 | 76,176 | 62,609 | 46,788 | 31,844 | 19,772 |
| NPV | 167,880 | 134,777 | 75,431 | 0 | (80,830) | (158,408) |
