Investment appraisal – Discounted cash flow techniques

Question 1

Money received today is worth more than the same sum received in the
future, i.e. it has a time value.
This occurs for three reasons:

Answer 1

 potential for earning interest/cost of finance
 impact of inflation
 effect of risk

Question 2

Compounding

Answer 2

A sum invested today will earn interest. Compounding calculates the future or
terminal value of a given sum invested today for a number of years.
To compound a sum, the figure is increased by the amount of interest it would
earn over the period.

Question 3

The NPV represents

Answer 3

the surplus funds (after funding the investment)
earned on the project

the NPV gives the impact of the project on shareholder wealth

Question 4

Advantages and disadvantages of using NPV

Answer 4

Advantages
Theoretically, the NPV method of investment appraisal is superior to all
others. This is because it:
 considers the time value of money
 is an absolute measure of return
 is based on cash flows, not profits
 considers the whole life of the project
 should lead to maximisation of shareholder wealth.
Disadvantages
 It is difficult to explain to managers
 It requires knowledge of the cost of capital
 It is relatively complex.

Question 5

Discounting annuities

Answer 5

An annuity is a constant annual cash flow for a number of years. The PV of the
entire set of annuity cash flows can be determined in a single calculation using
an annuity factor

Question 6

Discounting perpetuities

Answer 6

A perpetuity is an annual cash flow that occurs forever.

Question 7

The PV of a perpetuity is found using the formula

Answer 7

PV = Cash flow/ R

Question 8

The PV of a growing perpetuity is found using the formula

Answer 8

PV = cash flow at T1 × 1/r – g

Question 9

IRR of a perpetuity =

Answer 9

Annual inflow/
Initial investment ×100

Question 10

Advantages and disadvantages of IRR

Answer 10

Advantages
The IRR has a number of benefits, e.g. it:
 considers the time value of money
 is a percentage and therefore easily understood
 uses cash flows not profits
 considers the whole life of the project
 means a firm selecting projects where the IRR exceeds the cost of capital
should increase shareholders’ wealth

Disadvantages
 It is not a measure of absolute profitability.
 Interpolation only provides an estimate and an accurate estimate requires
the use of a spreadsheet programme.
 It is fairly complicated to calculate.
 Non-conventional cash flows may give rise to multiple IRRs, which means
the interpolation method can’t be used.
 Contains an inherent assumption that cash returned from the project will
be re-invested at the project’s IRR, which may be unrealistic

Question 11

NPV versus IRR

Answer 11

Both NPV and IRR are investment appraisal techniques that discount cash
flows and are superior to the basic techniques discussed in the previous
chapter. However only NPV can be used to distinguish between two mutually-
exclusive projects. NPV is therefore the better technique for choosing between projects

Question 12

The advantage of NPV is that

Answer 12

it tells us the absolute increase in
shareholder wealth as a result of accepting the project, at the current cost
of capital. The IRR simply tells us how far the cost of capital could
increase before the project would not be worth accepting