Discounting and Investment Appraisal Flashcards
Net Present Value
Gives a return in terms of cashflow generated by a project
Internal Rate of Return
Provides a % return figure
Returns on Capital Employed
Compares company’s capital with it’s earnings
Time Value of Money
Money is more valuable now than in the future as the value of money falls over time due to inflation.
Simple Interest
Considers how much was earned on the original amount (known as the principal)
Compound Interest
Considers how much is earned, taking into consideration each addition of the simple interest to the principle
Simple Interest Formula
V = P + (r x P x n)
V= value of investment at the end of the period P = amount invested r = rate of interest n = number of years it's invested for
Compound Interest Formula
V = P(1 + r)n
V =value of investment at the end of the period
P = amount invested
r = rate of interest
n = number of years invested for
Annualised Interest Rates
Annualised rate = (1 + period rate)X
X = number of periods in the year
Terminal Values
Sometimes money is invested more than once into a bank account. We must calculate terminal value, considering the time for which each different deposit has been earning interest.
Basically, calculate the interest earned on each year’s deposit and add them all together
Sinking Fund
Investments where a given amount is put in every year, usually used to pay off a debt or replace a specific asset
Discounting
Converting all future values of an investment opportunity into their current values so that they can be easily compared.
Calculating how much future returns would be worth now
Calculating Present Value
P = F x (1 + r)-n
OR
F
P = ———
(1 + r)n
P = present values F = future values r = rate of returns n = number of years invested for
Net Present Value
Calculate’s an organisation’s change in wealth if it undertakes a particular project
Positive & Negative NPV
Positive = a increase in total value of the company from doing the project
Negative = a decrease in total value of the company from doing the project
Assumptions Made When Using NPV
Cash outflows and inflows that occur during the year are treated as if they occurred at the end of that financial year
If you are specifically told that a cash inflow or outflow occurs at the start of the year, include it as the end of the previous year
Benefits and Negatives of NPV
Benefits:
Takes into account time value of money
Final result gives increased worth of the co
Negatives:
Discount rate is an estimate, not a guarantee
Cashflow assumptions adds some inaccuracy
The returns might not be as accurately predictable
Annuity
Financial instrument purchased for an initial sum which then pays out the same amount every year. It will pay out until:
- The policy owner dies
- The specified fixed period ends
- An event related to the policy occurs
Cumulative Discount Factor Formula
1/r (1 - 1/(1 + r)n)
r = rate of interest n = number of years invested for
Perpetuities
Financial instrument purchased for an initial sum which then pays out the same amount every year with no end
Discount Rate for a Perpetuity
r
r = rate of interest
Internal Rate of Return
Provides the discount rate at which the NPV of all cashflows from a project is 0
IRR Formula
NVPa
A + ——————– x (B - A)
NVPa - NVPb
A = NPV at the chosen cost of capital (discount rate) B = a chosen NPV, higher or lower than A
Advantages and Disadvantages of IRR
Advantages:
Takes time value of money into account
Gives a % measure, easy to understand
No need to know exact cost of capital
Disadvantages:
% measure, so not suitable for choosing between projects of different sizes
NPV is considered superior as it relates directly to the increase or reduction of business wealth
