Net Present Value (NPR) (DP IB Business Management)

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Lisa Eades

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Using the Net Present Value (NPV)

The Net Present Value (NPV) takes into account the effects of interest rates and time
It recognises
- The fact that that money received in the future is often worth less than money received today (inflation)
- The opportunity cost of not having the money available for other uses
To calculate the Net Present Value of an investment, the value of all future net cash flows in today’s terms need to be calculated first and then discounted using a table
The cost of the initial investment is deducted from the total of the discounted net cash flows
- If future net cash flows minus the initial investment are positive, then the investment is likely to be worthwhile
- If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile
Discounted cash flows are calculated using discount tables, which allow future cash flows to be expressed in today’s terms

Table: discount factors at different rates of interest

Worked Example

Brownsea Sightseeing Tours Ltd is considering purchasing a new pleasure craft at a cost of £325,000. It expects the investment to achieve the following net cash flows over five years of operation

Year	Net cash Flow (£)	10% Discount Factor (2dp)
0	(325,000)	1.00
1	110,000	0.91
2	90,000	0.83
3	75,000	0.75
4	65,000	0.68
5	60,000	0.62

Using the 10% discount factor calculate the NPV of the leisure craft investment. (4 marks)

Step 1 - Calculate the discounted cash flow for each year by multiplying the net cash flow by the discount factor

3-3-2-net-present-value-of-discounted-cash-flow

(2)

Step 2: Add together the discounted cash flow values for each year, including Year 0

$(£ 325, 000) + £ 100, 100 + £ 74, 400 £ 56, 250 + £ 44, 200 + £ 37, 200 = (£ 12, 550)$

(1)

The Net present Value of the investment is -£12,550

This negative outcome suggests that the investment in the new pleasure craft is not financially worthwhile

(1)

Advantages and Disadvantages of the Net Present Value Method

Advantages	Disadvantages
Considers the opportunity cost of money Discount tables are used to calculate forecast future values of net cashflows Businesses may choose different discount tables (20%, 10%, 5% etc) to adjust the level of risk involved in a project Can consider a range of scenarios	More complicated to calculate and interpret than other methods Accurately forecasting future cash flows is complex Choosing an appropriate discount rate can be 'hit and miss' Ignores non-financial benefits or costs e.g environmental damage

Advantages

Disadvantages

Considers the opportunity cost of money

Discount tables are used to calculate forecast future values of net cashflows
Businesses may choose different discount tables (20%, 10%, 5% etc) to adjust the level of risk involved in a project
- Can consider a range of scenarios

More complicated to calculate and interpret than other methods
Accurately forecasting future cash flows is complex
Choosing an appropriate discount rate can be 'hit and miss'
Ignores non-financial benefits or costs e.g environmental damage

Exam Tip

Being able to calculate the payback period, ARR or NPV of an investment is a key quantitative skill

More important, though, is interpreting the outcome of your calculation and using it to make a judgement

Is an investment worthwhile?
Which investment is the most profitable?
The costs of which investment will be recouped first?

Qualitative factors should be considered alongside calculations - review case study material carefully to select relevant information

Limitations of using Investment Appraisal

Each techniques relies upon forecasted future cash flows which may lack accuracy
- Managers may lack experience or may be biased towards a particular investment
- Incomplete past data may make forecasting imprecise or mean that confidence in the data is limited
Longer-term forecasts used to predict returns on investments may be inaccurate for a variety of reasons
- Unexpected increases in costs
- The arrival of new competitors
- Changes in consumer tastes
- Uncertainties arising as a result of economic growth or recession
Non-financial factors are ignored
- Business finances and availability of external finance to fund the investment
- Overall corporate objectives
- Potential for positive public relations or meeting social responsibilities

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