Discounting and Investment Appraisal

Question 1

Net Present Value

Answer 1

Gives a return in terms of cashflow generated by a project

Question 2

Internal Rate of Return

Answer 2

Provides a % return figure

Question 3

Returns on Capital Employed

Answer 3

Compares company’s capital with it’s earnings

Question 4

Time Value of Money

Answer 4

Money is more valuable now than in the future as the value of money falls over time due to inflation.

Question 5

Simple Interest

Answer 5

Considers how much was earned on the original amount (known as the principal)

Question 6

Compound Interest

Answer 6

Considers how much is earned, taking into consideration each addition of the simple interest to the principle

Question 7

Simple Interest Formula

Answer 7

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

Question 8

Compound Interest Formula

Answer 8

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

Question 9

Annualised Interest Rates

Answer 9

Annualised rate = (1 + period rate)X

X = number of periods in the year

Question 10

Terminal Values

Answer 10

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

Question 11

Sinking Fund

Answer 11

Investments where a given amount is put in every year, usually used to pay off a debt or replace a specific asset

Question 12

Discounting

Answer 12

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

Question 13

Calculating Present Value

Answer 13

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

Question 14

Net Present Value

Answer 14

Calculate’s an organisation’s change in wealth if it undertakes a particular project

Question 15

Positive & Negative NPV

Answer 15

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

Question 16

Assumptions Made When Using NPV

Answer 16

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

Question 17

Benefits and Negatives of NPV

Answer 17

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

Question 18

Annuity

Answer 18

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

Question 19

Cumulative Discount Factor Formula

Answer 19

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

r = rate of interest
n = number of years invested for

Question 20

Perpetuities

Answer 20

Financial instrument purchased for an initial sum which then pays out the same amount every year with no end

Question 21

Discount Rate for a Perpetuity

Answer 21

r

r = rate of interest

Question 22

Internal Rate of Return

Answer 22

Provides the discount rate at which the NPV of all cashflows from a project is 0

Question 23

IRR Formula

Answer 23

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

Question 24

Advantages and Disadvantages of IRR

Answer 24

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