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Financial Management
Slide 2 : 2 Section D: Investment appraisal Designed to give you knowledge and application of: D1. The nature of investment decisions and the appraisal process
D2. Non-discounted cash flow techniques
D3. Discounted cash flow (DCF) techniques
D4. Allowing for inflation and taxation in DCF
D5. Adjusting for risk and uncertainty in investment appraisal
D6. Specific investment decisions (lease or buy; asset replacement; capital rationing)
Slide 3 : 3 Learning Outcomes Discounted cash flow (DCF) techniques Explain and apply concepts relating to interest and discounting, including:[2]
the relationship between interest rates and inflation, and between real and nominal interest rates
the calculation of future values and the application of the annuity formula
the calculation of present values, including the present value of an annuity and perpetuity, and the use of discount and annuity tables
the time value of money and the role of cost of capital in appraising investments
Calculate net present value and discuss its usefulness as an investment appraisal method.[2]
Calculate internal rate of return and discuss its usefulness as an investment appraisal method.[2]
Discuss the superiority of DCF methods over non-DCF methods .[2]
Discuss the relative merits of NPV and IRR .[2]
Slide 4 : 4 Concepts relating to interest and discounting Example
Item Wye was priced at $1 on 1 January 20X8 and Peter could have purchased 100,000 Wyes with the given principal amount. Assuming inflation of 5%, the price of the item Wye became $1.05. On 1 January 20X9, he can purchase only 100,000/1.05= 95,238 units with the same amount. In other words, the purchasing power of the amount has been reduced by 100,000 - 95,238 = 4,762 units i. e. around 5%.
If Peter wants to retain the purchasing power of the principal amount, he will demand a higher rate of interest to compensate for losses incurred due to inflation.
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Slide 6 : 6 Example
Peter lends $100,000 to Robert on 1 January 2008 who is to return this after 1 year with 8% interest. After one year, Robert returns $100,000 + interest of $8,000.
Item Wye was priced at $1 on 1 January 20X8 and Peter could have purchased 100,000 Wyes with the given principal amount. Let us assume that inflation of 5% took place within a year and the price of the item Wye became $1.05. Now, when Peter gets back $100,000 on 1 January 20X9, he can purchase only 100,000/1.05= 95,238 units with the same amount. In other words, the purchasing power of the amount has been reduced by 100,000 - 95,238 = 4,762 units i.e. around 5%.
If Peter wants to retain the purchasing power of the principal amount, he will demand a higher rate of interest to compensate for losses incurred due to inflation.
Slide 7 : 7 Example
$100,000 is lent for 4 years at simple interest of 10%. Interest is equal to 100,000 x 10% =10,000 per year. The total interest is equal to 10,000 x 4 = 40,000. The future value of the initial investment of $100,000 is $140,000
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Slide 10 : 10 Example
$100,000 is lent for 4 years at a yearly compound interest of 10%.
The compounding of interest is done semi-annually.
With half yearly compounding, the future value will be calculated as follows:
Interest rate for half year is 10/2 = 5%
Number of periods in half years = 4 x 2 =8
FV = $100,000 x (1+ 0.05) 8
= $100,000 x 1.05 8
= $100,000 x 1.477455
= $147,745.5
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Slide 13 : 13 Example
Wellpack Co’s average cost of capital is 8%. It receives two alternative investment proposals. One gives a return of 10% and the other 6%. The company will accept the first and reject the second proposal. The company cannot afford to pay a cost of capital of 8% if it earns only 6% by investing the same amount in the business.
Slide 14 : 14 Calculate net present value (NPV) and discuss its usefulness as an investment appraisal method. NPV = Present value of cash inflows - Present value of cash outflows
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Slide 16 : 16 Example
A cash payment of $60,000 on 1 January 2008 will be occurred in 2007, for the purpose of cash flow discounting.
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Slide 18 : 18 Calculate internal rate of return (IRR) and discuss its usefulness as an investment appraisal method.
Slide 19 : 19 Example
Strilco is considering an investment proposal with an initial investment outlay of
$6,000. It expects the annual cash inflow to be $1,450 in the next 6 years.
Calculate the IRR for the project. Continued …..
Slide 20 : 20 Answer
Strilco has an identical cash inflow of $1,450 for six years consecutively. It uses the
cumulative present value factors table to calculate the IRR.
In this case, the inflows are identical. Therefore, we can use the cumulative present value
factors table.
As we know, IRR represents the rate where NPV is nil.
Therefore,
($1,450 x CPVFr,6) - $6,000 = 0
Where CPVFr,6 is the cumulative present value factor for 6 years, and r is IRR.
CPVFr,6 = 6,000/1,450
= 4.137931
Looking at the cumulative present value factors table and checking the row for 6 years, we
find that the value of 4.111 which is the nearest to 4.137 , appears in the column of 12%.
Therefore, we can conclude that the internal rate of return is approximately 12%.
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Slide 24 : 24 Superiority of Discounted Cash Flow methods over non-Discounted Cash Flow methods.
Slide 25 : 25 Relative merits of NPV and IRR
Slide 26 : 26 Recap – Can You : Explain relationship between interest and inflation?
Explain relationship between real and nominal interest rates.
Calculate future values?
Calculate present values?
Explain time value of money?
Explain Net present value?
Calculate Net present value?
Explain the timing assumptions or conventions?
Explain Internal rate of return?
Calculate IRR when project cash inflows are identical?
Calculate IRR when project cash inflows are not identical?
Explain how are DCF techniques better than Non-DCF techniques?
Explain the relative merits of NPV and IRR?