INVESTMENT APPRAISAL: NET PRESENT VALUE A2 Business Studies

Aims and Objectives Aim: Understand NPV Method Objectives: All Will: Define NPV All Will: Explain the technique. All Will: Calculate NPV Most Will: Analyse NPV method Some Will: Evaluate NPV method

Starter Give 2 benefits of the ARR method. Give 2 drawbacks of the ARR method.

Definitions Discount factor: the rate by which future cash flows are discounted (reduced) to reflect the current interest rate.

Net Present Value Method Considers the total return from an investment in today’s terms. It recognises that £100 received today from the investment is worth more than £100 received in the future. Due to inflation. It calculates the net cash gain in today’s money terms.

Machine A YearNet Cash Flow 10% Discount Factor NPV 0(£750,000)1 1£142, £192, £252, £252, £292, Net Present Value Step 1: Multiply each year’s net cash inflow by the relevant discount factor, to calculate the NPV.

Machine A Step 2: Add up all the NPVs to calculate the net cash gain from the project expressed in today’s terms. Now Calculate NPV for Machine B Machine B

Analysis Analysis: If project is predicted to produce a positive NPV then it should be accepted. If choosing between two investments, the highest NPV should be selected. If the NPV is negative then the project should be rejected. Positive NPV = Accept Negative NPV = Reject

Evaluation Advantages: Takes account of the fact that £1 today is worth less than £1 in the future; due to purchasing power falling and inflation changing. Disadvantages: Doesn’t take into account the speed of repayment, and it can be difficult to choose the correct discount factor, which non-financial managers can find hard to understand.

Further Exam Evaluation All three investment appraisal techniques are based on predictions of future cash inflows and outflows. How far into the future are these predictions being made? By who? Do they have any expertise? Do they have any financial experience?

Investment Criteria In groups decide on a definition of Investment Criteria. Definition: A target against which an investment decision is judged.

Investment Criteria Criterion levels are minimum levels/targets which must be met. Specific criteria will depend on the nature of the business, the investment, the culture, their attitude to risk.

Risks Investment decision carry risk, and the potential gain from risk carries a reward. In groups decide on a number of factors which determine the level of risk of an investment.

Risks Sum of money to be invested. 1 The length of time the business must commit to the project 2 Impact of investment on other parts of business 3 Ease or difficulty with which the investment can be reversed 4 Impact of the decision on future choices. 5

Uncertainty The degree of uncertainty associated with a project will be determined by a number of factors. In groups decide what factors may determine how uncertain managers may be with regard to an investment decision.

Uncertainty Stability of the market and accuracy of sales forecasts 1 Credibility of the figures 2 Stability of the economic environment 3 Competitors reactions to potential investment 4 Overall time period of future projections 5

Qualitative Factors An investment may look good when just considering figures. What if investment causes: unemployment, negative publicity or is damaging to the businesses image? Businesses must consider qualitative factors!

Homework Revise the following for practice exam question: Meaning of ratios Payback method NPV method Evaluating and analysing investment appraisal methods