《《Capital Investment Appraisal 2》.pptVIP

Capital Investment Appraisal 2 Given a choice between receiving ￡100 today or receiving ￡100 in one year’s time, most people would consider there to be an inequality between the two options Three basic reasons include Interest lost Risk Effects of inflation Interest lost Receiving ￡100 in one year’s time deprives recipient of spending the ￡100 now Also deprives recipient of depositing the ￡100 in a bank or building society which would have given a years worth of interest. Risk There is always an element of risk in any investment Benefits can only be an estimate An investor investing ￡100 would require a compensating return for taking the risk The higher the perceived risk the higher the compensation required ￡100 return for ￡100 deposited gives no incentive for the risk of failure in one year’s time Effects of Inflation Where prices are rising ￡100 today has greater buying power than ￡100 received in a year’s time This is known as inflation A person deprived of their ￡100 for a year will require compensation for loss of buying power. Having considered these reasons it would seem apparent that an investment appraisal technique is required that: Takes account of all the costs in an investment Takes account of all the benefits of an investment Allows for the TIMING of these costs and benefits Net Present ValueHow does it work? The initial investment is known and invested immediately The life of the project and cash flows for each year are estimated The cash flows will be at today’s values A discount rate is determined The cash flows are discounted for each year The sum of the discounted cash flows are compared to the initial investment Positive NPV results are worthwhile projects Example A project has an initial investment of ￡100,000 with a disposal value of ￡30,000 in 6 years time. Cash flows are estimated at ￡30,000 per year and a discount factor has been decided at 20% Year Cash flow DF Present value ￡ 20% ￡ 0 (100,000) 1.0 (100,000)