CH18: Discounting and Investment Appraisal

Question 1

What are the 2 ways to calculate interest?

Answer 1

Simple Interest and Compound interest

Question 2

Definition: simple interest

Answer 2

Amount earned on the original amount (known as the principal)

Question 3

Definition: compound interest

Answer 3

Amount earned, taking in to consideration each addition of the simple interest to the principal (i.e. the cumulative interest added to the principal amount)

Question 4

Formula: simple interest

Answer 4

V=P+(rxPxn)

V= the value of the investment at the end of the particular time period
P= The principal amount/ original amount invested
r= interest rate 
n= number of years it is invested for

Question 5

Formula: compound interest

Answer 5

V=P(1+r)^n

V= the value of the investment at the end of the particular time period
P= The principal amount/ original amount invested
r= interest rate 
n= number of years it is invested for

Question 6

Formula: Annualised interest rate

Answer 6

Annualised Interest Rate = (1+ period rate)^x

x= the number of periods in a year
i.e. if the interest is paid every 6 months then x would be 2 (2 lots of 6 months in a year/12 months)

Question 7

Terminal Values

Answer 7

If money is invested more than once into a bank account. We must calculate the terminal value, considering the time for which each different deposit has been earning interest using the compound interest formula V=P(1+r)^n.

Question 8

Sinking fund

Answer 8

Investment where a given amount is put in every year, usually used to pay off a debt or replace a specific asset . uses the compound interest formula V=P(1+r)^n.

Question 9

Definition: Discounting

Answer 9

Converting all future values of an investment opportunity into their current/present values so they can be easily compared (i.e. calculating how much the future returns would be worth now)

Question 10

Formula: present value

Answer 10

P= F x (1+r)^-n or P=F/(1+r)^n

P= Present values
F=future values
r= rate of interest
n= amount of years it is invested for

the Discount factor is represented by (1+r)^-n

*Discount factor tables provided in the exam

Question 11

What does the Net Present Value demonstrate?

Answer 11

Calculates an organisation’s change in wealth if it undertakes a particular project (i.e cashflows generated by a project).

*If there are two projects with positive NPVs, the one with a higher NPV should be chosen

Question 12

What are assumptions which are made when using the NPV?

Answer 12

Cash outflows or inflows that occur during any particular period are all treated as if they occurred at the end of that financial year .

If you are told that the cash outflow/inflow happened at the start of the year - include it as the end of the previous year.

Question 13

Benefits of NPV?

Answer 13

Factors in time value of money

Final result gives the change in wealth of the business

Easy to understand

Question 14

Negatives of NPV?

Answer 14

Discount rate cannot be guaranteed as future rates change, hence NPV is an estimate

Inaccuracies due to assumption that all cash in/out flows happen at the end of a period

The returns may not be accurately predictable

Inflation is not factored in

need to know exact cost of capital

Question 15

Definition: Annuity

Answer 15

A financial instrument purchased for an initial sum which pays out the same amount each and every year

Question 16

What formula is used to calculate value of annuities?

Answer 16

cumulative discount factor formula

*note the cumulative present value table is given in the exam

Question 17

Formula: cumulative discount factor formula

Answer 17

1-(1+r)^-n/r

Question 18

What is the difference between an Annuity vs. Perpetuity?

Answer 18

Perpetuity has no end date

Question 19

Formula: discount rate for a perpetuity/ present value of a perpetuity

Answer 19

1/r

Question 20

Definition: Internal rate of return/IRR

Answer 20

provides the discount rate at which the net present value of all cash flows from a project is 0.

• the discount rate is aka the cost of capital; reflects the returns demanded by shareholders on a project.
  i. e. tells us what the cost of capital should be for the project to at least breakeven

Question 21

Advantages of using IRR?

Answer 21

Provides time value of money

There is no need to know the exact cost of capital

easy to understand

Question 22

disadvantages of using IRR?

Answer 22

As it is a % measure, it is not suitable for choosing between projects of different sizes

NPV is considered the superior tool for project assessment as it relates directly to change in wealth of the business

Question 23

How does NPV take in to account the time value of money?

Answer 23

Through discounting future cashflows, so that the later they arise, the less value they have

Question 24

What is the formula for the discount factor on an investment?

Answer 24

(1+r)^-n

Question 25

What do you need to know to calculate the NPV of a project?

Answer 25

The discount rate
length/duration of the project
the initial cost of the project
the scrap value of the project