Investment Appraisal Methods Notes

Inflation: Inflation erodes the purchasing power of money over time. When estimating cash flows, it's crucial to adapt both the cash flows (nominal cash flows, which include inflation) and the discount rates (nominal discount rates, which also include inflation) to reflect inflationary impacts. Alternatively, real cash flows (without inflation) can be discounted by real discount rates. Consistency is key (nominal with nominal, real with real) to ensure the value of future cash flows is accurately assessed.
Investment in Working Capital: New projects often require additional funding for working capital (e.g., increased inventory, accounts receivable, or cash balances) to support operations. This initial investment in working capital represents a cash outflow at the beginning of the project. However, it is typically recovered at the end of the project's life when operations cease and the working capital is released, resulting in a cash inflow.
Interest Payment: Although interest payments on debt used to finance the project are deductible for tax purposes, they should not be included directly as cash outflows in the domestic investment appraisal when using Net Present Value (NPV). This is because the cost of financing (debt and equity) is already implicitly factored into the discount rate (cost of capital or WACC) used to calculate the NPV. Including interest payments in the cash flows would result in double-counting the cost of finance.

Risk: In financial decision-making, risk is defined as a situation where there are multiple possible outcomes for a project, and the probability of each outcome occurring is known or can be reliably estimated (e.g., based on historical data or statistical analysis). Risk increases with greater variability (wider dispersion) of potential outcomes, even if the expected outcome is the same.
Uncertainty: Uncertainty, on the other hand, describes situations where future outcomes are unknown, and the probabilities of these outcomes cannot be objectively assigned or predicted. This can arise from entirely new projects or highly volatile economic scenarios where historical data is not representative or available. Predictions under uncertainty are often based on subjective judgment rather than quantifiable probabilities.
Incorporating Risk: To evaluate project investment under risk, various tools can be employed. One common method is to use probability distributions to calculate the Expected Net Present Value (ENPV), which considers all possible outcomes and their likelihoods. Other methods include adjusting the discount rate (higher for riskier projects) or performing sensitivity analysis.

Expected NPV Example

Calculation: The Expected Net Present Value (ENPV) is calculated by multiplying the NPV of each possible outcome by its probability and summing these products:
$\text{ENPV} = \sum<em>{i=1}^{N} p</em>i \cdot \text{NPV}<em>i$ Where $p</em>i$ is the probability of outcome $i$ , and $\text{NPV}_i$ is the NPV associated with outcome $i$ . For example, if a project has a 20% chance of a £50,000 NPV (best case), a 60% chance of a £20,000 NPV (most likely), and a 20% chance of a £5,000 NPV (worst case), the ENPV would be: $(0.20 \times £50,000) + (0.60 \times £20,000) + (0.20 \times £5,000) = £10,000 + £12,000 + £1,000 = £23,000$

Purpose: Sensitivity analysis is a technique used to evaluate project uncertainty by assessing how the project's Net Present Value (NPV) changes in response to changes in key underlying assumptions or variables. It helps identify which variables have the most significant impact on a project's profitability and risk, providing insights into areas that require closer monitoring or more detailed forecasting.
Methods: This involves systematically changing one variable at a time (e.g., sales volume, initial investment, production costs, discount rate) while holding all other variables constant. For each change, the new NPV is computed. This process helps determine the