Business finance : theory and practice

Chapter 4 • Investment appraisal methods
Summary
Net present value (NPV)
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NPV = the sum of the discounted values of the cash flows from the investment.
Money has a time value.
Decision rule: All positive NPV investments enhance shareholders’ wealth; the
greater the NPV, the greater the enhancement and the more desirable the project.
PV of a cash flow (C n ) = C n /(1 + r) n , assuming a constant interest rate.
The act of discounting brings cash flows at different points in time to a
common valuation basis (their present value), which enables them to be directly
compared.
Conclusions on NPV:
l Relates directly to shareholders’ wealth objective.
l Takes account of the timing of cash flows.
l Takes all relevant information into account.
l Provides clear signals and practical to use.
Internal rate of return (IRR)
l IRR = the discount rate that causes a project to have a zero NPV.
l It represents the average percentage return on the investment, taking account
of the fact that cash may be flowing in and out of the project at various points
in its life.
l Decision rule: Projects that have an IRR greater than the cost of financing them
are acceptable; the greater the IRR, the more desirable the project.
l Usually cannot be calculated directly; a trial and error approach is usually
necessary.
l Conclusions on IRR:
l It does not relate directly to shareholders’ wealth. Usually it will give the
same signals as NPV, but it can mislead where there are competing projects
of different scales.
l Takes account of the timing of cash flows.
l Takes all relevant information into account.
l Does not always provide clear signals and can be impractical to use:
l Often cannot cope with varying costs of finance.
l With unconventional cash flows, problems of multiple or no IRR.
l Inferior to NPV.
Payback period (PBP)
l PBP = the length of time that it takes the cash outflow for the initial investment
to be repaid out of resulting cash inflows.
l Decision rule: Projects with a PBP up to defined maximum period are acceptable;
the shorter the PBP, the more desirable the project.
l Can be refined a little by using discounted future inflows to derive a discounted
PBP.
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