Chapter 11 - Investment appraisal - discounting

Question 1

1. What is the time value of money?
2. Why does it exist?

Answer 1

1. The principle that £1 today is worth more than £1 in the furture.
2. Inflation, risk & interest

Question 2

1. What is compounding?
2. What is the formula for this

Answer 2

1. Compounding → A way to find the terminal value of cash flow (How much an amount invested today will be worth in the future).
   2.

Question 3

To find out how much a single cash flow recieved in the future is worth today what calculation is performed.

Answer 3

Dicounting to present value

Question 4

1. How is Net present value (NPV) calculated?
2. How does NPV show if a project is finacially viable?

Answer 4

1. The sum of the presnt values of all cash flows that arise from a project.
2. If NPV > 0 the project is financially viable.

Question 5

Answer 5

Question 6

1. What is ‘discounting annuities’?
2. What is the formula to calulate the present value of a perpetuity?

Answer 6

1. An annuity is a constant annual cash flow for a number of years → The present Value can be found using a formula or an annuity table

Question 7

1. What is ‘discounting perpetuity’?
2. What is the formula to calulate the present value of a perpetuity?

Answer 7

1. A perpetuity is annuity that last forever → a cash flow that will continue for the foreseeable future.
2. PV = Cashflow x (1 / interest rate)

Question 8

1. What are advanced annuities and perpetuities
2. How is this calculated, using the following question to explain…

Answer 8

1. When a regular cash flow starts immediatly instead of after the first year.
2. Calculate as normal excluding T₀ adding 1 to the AF value.

Question 9

Answer 9

Question 10

1. What is delayed annuity and perpetuity?
2. Answer the following to show how is is calculated.

Answer 10

1. When a regular cash flow starts later than T₁.

Question 11

What is Net Termianl Value (NTV)?

Answer 11

• The value of a project at the end of thr project
• A NTV discounted at the projects discount rate gived the NPV

Question 12

What is the Discounted Payback Period (DPP)?

Answer 12

The amount of time that the projects cumulative NPV takes to turn from negative to positive.

Question 13

What are the advantages and disadvantages of NPV?

Answer 13

Question 14

What are the features of internal rate of return? (3 points)

Answer 14

• It represents the discount rate at which the NPV of an investment is zero → therefore telling us the discount rate which would turn a product from beig worthwile to undeirable
• It can be found by linear interpolation → graph or formula
• Projects should be accepeted if IRR is greater than the cost of capital

Question 15

How do we calculate an estimate of IRR using linear interpolation?

Answer 15

1. Calulate the NPV at 2 different discount rates → (trial and error to get 1 positive and 1 negative NPV)
2. Use the formula to estimate IRR

Question 16

Answer 16

Question 17

How is the IRR of a prodjected calculated with even cash flow (annuities)… use the following question to explain.

Answer 17

Question 18

How is the IRR of a prodjected calculated where chas flows are perpetuities?

Answer 18

IRR of a perpetuity = (Annual inflow / Initial investment) x 100

Question 19

What are the advantages and disadvanatges of IRR?

Answer 19

Question 20

1. What is the prefered discount investment apprasial technique?
2. When must NPV be used instead of IRR? (3 points)

Answer 20

1. NPV
2. When Prevent Value changes signs (+/-) more than once over the investment lifetime

• When making a choice of what project to undertake when there are multiple project options.
• When cashflow is uneven.