Investment Appraisal: Net Present Value

# Investment Appraisal: Net Present Value

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## Investment Appraisal: Net Present Value

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1. Investment Appraisal: Net Present Value A2 Business Studies

2. 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

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

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

5. 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.

6. Machine A Step 1:Multiply each year’s net cash inflow by the relevant discount factor, to calculate the NPV.

7. 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

8. 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

9. 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.

10. 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?

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

12. 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.

13. 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.

14. Risks

15. 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.

16. Uncertainty

17. 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!

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