Managing Financial Principles and Techniques
Part 1: Financial Appraisal techniques
Part 2: Forecasting
Part 1-Financial Appraisal Techniques
NET PRESENT VALUE (NPV)
PROJECT X £000
Project Y £ 000
1)NET PRESENT VALUE (NPV)
Cumulative Cash Flow
PROJECT X £000
Project Y £ 000
Net Present value
The present value of an investments future net cash flows minus the initial investment. If positive, the investment should be considered (unless an even better investment exists), otherwise it should not. It is a calculation based on the idea that £1 received in ten years time is not worth as much as £1 received now because the £1 received now could be invested for those ten years and compound into a higher value. The NPV calculation establishes what the value of future earnings is in todays money. To do the calculation you apply a discount % rate to the future earnings. NPV is said to be short for net present value, it is the present value of net cash flows. It is commonly used for appraisals on projects. The advantage of using NPV is that it tells you if a project will add or deduct value from the business and hence decisions are taken of whether to accept it or reject it.
-It will also give accurate position for commonly special projects. -It gives an absolute value.
-NPV allow for the time value for the cash flows considers both magnitude and timing of cash flows •
Consistent with shareholder wealth maximization: Added net present values generated by investments are represented in higher stock prices. •
Indicates whether a proposed project will yield the investor’s required rate of return
It is very difficult to identify the correct discount rate. •
Many people find it difficult to work with a dollar return rather than a percentage return because it is hard to directly compare projects unlike say a percentage return as calculated using IRR •
It needs to be interpreted carefully because the overall NPV reflects the scale of the project as well as the rate of return.
Like the NPV method used for capital budgeting, the IRR method also uses cash flows and recognizes the time value of money. NPV and IRR may give conflicting decisions where projects differ in their scale of investment.
IRR allows you to compare projects easily because it is a percentage •
Also it can direct attention to situations where it might be better to do multiple versions of the same project with a high IRR •
In calculating IRR it can give an indication of how sensitive the Net Present Value is to changes in discount rate •
Considers both the magnitude and the timing of cash flows Disadvantage
Multiple internal rates of return with unconventional cash flows •
Any change in sign (+,-) in period cash flows produces as many IRR’s as there are changes in the cash flow directions of the investment, lending or borrowing. •
Assumes cash flow is reinvested at the IRR rate and this may not be a realistic assumption
NPV and IRR compared
NPV assumes that project cash flows are reinvested at the company's required rate of return; the IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep finding projects that would reinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever, thus NPV is more accurate. NPV method assumes that CFs are reinvested at the cost of capital K IRR method assumes that CFs...
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