2: NPV

Question 1

What is ‘payback’?

Answer 1

The amount of time it takes for an investment to recoup its initial cost.

Question 2

What are the advantages of ‘payback’? (4)

Answer 2

• Simple and quick.
• Good for early stage appraisal.
• Minimises risk.
• If quick return on capital is vital, then this should be considered with great importance.

Question 3

What are the disadvantages of ‘payback’? (2)

Answer 3

• Does not look beyond the payback period.
• No account of timing or rate of return.

Question 4

What is the formula for payback period?

Answer 4

Payback period = initial investment / annual cashflow

Question 5

What is ‘Net Present Value’ (NPV)?

Answer 5

The sum of future net cashflows discounted to a common base time, usually the present.

Question 6

What are the advantages of ‘NPV’? (4)

Answer 6

• Good indication of return value compared to a benchmarked RoR.
• Easily understood.
• Good for projects that appear quite different in terms of return.
• Considers the time value of money.

Question 7

What are the disadvantages of ‘NPV’? (1)

Answer 7

• Calculation is fairly complicated.

Question 8

What is the formula for ‘NPV’?

Answer 8

NPV = Sum (Ct/(1+r)^t) - Co

Question 9

What do the following represent in the ‘NPV’ formula?
- Ct
- Co
- r
- t

Answer 9

Ct =Net cash inflow during period ‘t’
Co = Total initial investment costs
r = discount rate (decimal)
t = number of time periods (years)

Question 10

What is ‘internal rate of return’ (IRR)?

Answer 10

The rate at which future cashflows, when discounted back, equate to the initial investment.

Question 11

How is IRR calculated?

Answer 11

Through trial and error, with the initial value informed by the calculation of NPV and how close the £ value is to zero.

Question 12

What are the advantages of ‘IRR’? (4)

Answer 12

• Gives precise information about RoR of a particular project.
• Can be compared to a benchmark value.
• Good for use in projects that appear quite different in terms of return.
• Considers time value of money.

Question 13

What are the disadvantages of ‘IRR’? (1)

Answer 13

• Time consuming.

Question 14

What is the formula for present worth factors?

Answer 14

1/(1+RoR)

I.e. 1/(1+0.1) would give the present worth factor for one year based on a compound RoR of 10%.

Question 15

How is the ‘NPV’ ranked?

Answer 15

The project with the highest NPV is preferred.

Question 16

How is ‘payback’ ranked?

Answer 16

The project with the shortest payback is preferred.

Question 17

What is the formula for working out the payback year in decimals in case payback occurs in the same year?

Answer 17

Previous year + (-1 x (cumulative income of final -ve year/income of same year))

i.e. 3 + (-1 x (-250,000/300,000)) = 3.8 yrs

Question 18

What else should be considered when determining the preferred project?

Answer 18

The initial capital of the project, i.e. how much the initial investment costs.

Question 19

What factors may influence the rate of return value used? (3)

Answer 19

• Cost of capital (debt, equity)
• Project risk (industry, project specific)
• Economic environment (interest, inflation)