2: NPV Flashcards
What is ‘payback’?
The amount of time it takes for an investment to recoup its initial cost.
What are the advantages of ‘payback’? (4)
- 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.
What are the disadvantages of ‘payback’? (2)
- Does not look beyond the payback period.
- No account of timing or rate of return.
What is the formula for payback period?
Payback period = initial investment / annual cashflow
What is ‘Net Present Value’ (NPV)?
The sum of future net cashflows discounted to a common base time, usually the present.
What are the advantages of ‘NPV’? (7)
- 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.
- Takes into account the timing of cashflow
- Takes into account RoR
- Applicable to all schemes
What are the disadvantages of ‘NPV’? (4)
- Calculation is fairly complicated.
- Can be inaccurate if IRR is calculated wrongly.
- Cash flows are predicted and could be wrong.
- Assumes a fixed RoR over the entire period, whereas RoR can change year on year.
What is the formula for ‘NPV’?
NPV = Sum (Ct/(1+r)^t) - Co
What do the following represent in the ‘NPV’ formula?
- Ct
- Co
- r
- t
Ct =Net cash inflow during period ‘t’
Co = Total initial investment costs
r = discount rate (decimal)
t = number of time periods (years)
What is ‘internal rate of return’ (IRR)?
The rate at which future cashflows, when discounted back, equate to the initial investment.
How is IRR calculated?
Through trial and error, with the initial value informed by the calculation of NPV and how close the £ value is to zero.
What are the advantages of ‘IRR’? (4)
- 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.
What are the disadvantages of ‘IRR’? (1)
- Time consuming.
What is the formula for present worth factors?
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%.
How is the ‘NPV’ ranked?
The project with the highest NPV is preferred.
How is ‘payback’ ranked?
The project with the shortest payback is preferred.
What is the formula for working out the payback year in decimals in case payback occurs in the same year?
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
What should be considered when determining the preferred project? (4)
Highest NPV.
Shortest Payback period.
The initial capital of the project, i.e. how much the initial investment costs.
Cumulative net income over the duration.
What factors may influence the rate of return value used? (4)
What does 10% RoR allow for? (3)
- Cost of capital (debt, equity)
- Project risk (industry, project specific)
- Economic environment (interest, inflation)
- whether a RoR is in mind for comparison purposes
- 10% RoR allows for borrowing capital, inflation, and still leaves room for added return
When an NPV question has multiple outgoings, how do you calculate payback and the present value?
For example, what if the outgoing for year 5 was -10m and the incoming was only +7.5m?
Create a table with additional columns for cumulative net (to calculate payback) and net income (to calculate values for NPV formula)
Use the net income column for the NPV calculations, so year 5 = -2.5m
When calculating the IRR, how do you know which way to estimate the RoR next?
a negative NPV means the RoR % needs to be lowered
a positive NPV means the RoR % needs to be raised
