Accounts & Finance

1. Accounts & Finance Investment Appraisal HL Only

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

3. Discounted cash flow • “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

4. 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.

5. 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

6. 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.

7. 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

8. DiscountFactors • Thesewill be providedon a seperatesheet in theexam as additional material

9. Net Present Value • 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

10. NPV • Three stages in calculating NPV: • Multiply discount factors by the cash flows • Add discounted cash flows • Subtract capital cost to give NPV Cash flow in year 0 are never discounted as they are todays values already

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

12. 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

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

14. 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

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

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

19. 19.6-8.4 =11.2 11.2 / 6 = 1.86 1.86 / 8.4 = 0.222 0.222 * 100 = 22%

20. 11.5 – 4.4 =7.1 7.1 / 6 = 1.183 1.183 / 4.4 = 0.268 0.268 * 100 = 26.8%