INVESTMENT APPRAISAL: NET PRESENT VALUEA2 Business Studies

Aims and Objectives

Aim:

• Understand NPV Method

Objectives:

• All Will: Define NPV• All Will: Explain the technique.• All Will: Calculate NPV• Most Will: Analyse NPV method• Some Will: Evaluate NPV method

Starter

•Give 2 benefits of the ARR method.

•Give 2 drawbacks of the ARR method.

Definitions

• Discount factor: the rate by which future cash flows are discounted (reduced) to reflect the current interest rate.

Net Present Value Method

• Considers the total return from an investment in today’s terms.

• It recognises that £100 received today from the investment is worth more than £100 received in the future. Due to inflation.

• It calculates the net cash gain in today’s money terms.

Machine AYear Net Cash Flow 10% Discount

FactorNPV

0 (£750,000) 1  

1 £142,500 0.91  

2 £192,500 0.83  

3 £252,500 0.75  

4 £252,500 0.68  

5 £292,500 0.62  

Net Present Value  

Step 1: Multiply each year’s net cash inflow by the relevant discount factor, to calculate the NPV.

Machine AStep 2:Add up all the NPVs to calculate the net cash gain from the project expressed in today’s terms.

Now Calculate NPV for Machine B

Machine B

Analysis

Analysis:• If project is predicted to produce a positive NPV then it

should be accepted.

• If choosing between two investments, the highest NPV should be selected.

• If the NPV is negative then the project should be rejected.

• Positive NPV = Accept

• Negative NPV = Reject

Evaluation

• Advantages: Takes account of the fact that £1 today is worth less than £1 in the future; due to purchasing power falling and inflation changing.

• Disadvantages: Doesn’t take into account the speed of repayment, and it can be difficult to choose the correct discount factor, which non-financial managers can find hard to understand.

Further Exam Evaluation

• All three investment appraisal techniques are based on predictions of future cash inflows and outflows.

• How far into the future are these predictions being made? By who?

• Do they have any expertise?

• Do they have any financial experience?

Investment Criteria

• In groups decide on a definition of Investment Criteria.

Definition:• A target against which an investment decision is judged.

Investment Criteria

• Criterion levels are minimum levels/targets which must be met.

• Specific criteria will depend on the nature of the business, the investment, the culture, their attitude to risk.

Risks• Investment decision carry risk, and the potential gain from

risk carries a reward.

• In groups decide on a number of factors which determine the level of risk of an investment.

Risks

• Sum of money to be invested.1• The length of time the business must

commit to the project2• Impact of investment on other parts of

business3• Ease or difficulty with which the

investment can be reversed4• Impact of the decision on future

choices.5

Uncertainty• The degree of uncertainty associated with a project will be

determined by a number of factors.

• In groups decide what factors may determine how uncertain managers may be with regard to an investment decision.

Uncertainty• Stability of the market and accuracy

of sales forecasts1• Credibility of the figures2• Stability of the economic environment3• Competitors reactions to potential

investment4• Overall time period of future

projections5

Qualitative Factors

• An investment may look good when just considering figures.

• What if investment causes: unemployment, negative publicity or is damaging to the businesses image?

• Businesses must consider qualitative factors!

Homework• Revise the following for practice exam question:

• Meaning of ratios

• Payback method

• NPV method

• Evaluating and analysing investment appraisal methods