Financial Management - Investment Appraisal Notes

Discounted Payback Period

  • Basic Payback Period (PBP) ignores the time value of money.

  • Discounted PBP uses discounted cash flows, leading to a longer payback period but retains criticisms of basic PBP.

  • Example:

    • Year 0: Cash flow = $-120,000 (cumulative = $-120,000)

    • Year 1: Cash flow = $50,000 (cumulative = $-70,000)

    • Year 2: Cash flow = $60,000 (cumulative = $-10,000)

    • Year 3: Cash flow = $80,000 (cumulative = $70,000)

    • Year 4: Cash flow = $40,000 (cumulative = $110,000)

    • Payback occurs between years 2 & 3.

Internal Rate of Return (IRR)

  • Definition: The discount rate that results in an NPV of zero; represents the annual rate of return on a project.

  • Decision Rule: Accept project if IRR > opportunity cost of capital, reject if IRR <.

  • Calculation involves trial and error with positive and negative NPVs.

  • Example:

    • Cash flows discounted at 35% result in a NPV of $-5,490.

    • Interpolation helps find IRR between rates associated with different NPVs.

Net Present Value (NPV)

  • NPV exemplified with cash flows discounted at 8%.

  • Total NPV calculated as $70,640.

Annuities

  • Definition: Constant cash flow for a fixed number of years.

  • Example: £100 per year for 3 years at 12% interest results in a present value of £240.20.

  • Use of annuity factors simplifies calculations.

Risk and Sensitivity Analysis

  • Cash flow estimates pose risk; actual results may vary.

  • Sensitivity analysis examines NPV's responsiveness to cash flow changes.

  • Example questions:

    • How does a 10% drop in selling price affect NPV?

    • Which component of cash flow causes most sensitivity?

  • Potential misleading interpretations without considering the likelihood of change.

Unequal Lives

  • When evaluating mutually exclusive projects with different lifespans, compare NPVs.

  • Replacement Chain method: Use the least common multiple of project lives.

  • Terminal value: Calculate value at the shorter project's end for the longer one.

  • Recommendation: Review relevant textbooks for further insights on complex topics like IRR and sensitivity analysis.