BUSF_A01.qxd

Chapter 4 • Investment appraisal methods

There is no reason why the interest rate should be the same from one year to the

next; in practice, financing costs alter over time. If the financing cost were r 1 for year 1

and r 2 for year 2, the present value of the year 2 cash flow would be:

Note that it is as logical to discount future paymentsas it is to discount future

receipts, where the investment opportunity involves a future payment.

C 2

(1 + r 1 )(1 +r 2 )

Seagull plc has identified that it could make operating cost savings in production by buying

an automatic press. There are two suitable such presses on the market, the Zenith and the

Super. The relevant data relating to each of these are as follows:

Zenith Super

££

Cost (payable immediately) 20,000 25,000

Annual savings:

Year 1 4,000 8,000

2 6,000 6,000

3 6,000 5,000

4 7,000 6,000

5 6,000 8,000

The annual savings are, in effect, opportunity cash inflows in that they represent savings

from the cash outflows that would occur if the investment were not undertaken.

Which, if either, of these machines should be bought if the financing cost is a constant

12 per cent p.a.?

Example 4.1

The NPV of each machine is as follows:

Zenith Super

££

Present value of cash flows:

Year 0 (20,000) (25,000)

1 =3,571 =7,143

2 =4,783 =4,783

3 =4,271 =3,559

4 =4,449 =3,813

5 =3,405 =4,539

479 ( 1,163)

8,000

(1 +0.12)^5

6,000

(1 +0.12)^5

6,000

(1 +0.12)^4

7,000

(1 +0.12)^4

5,000

(1 +0.12)^3

6,000

(1 +0.12)^3

6,000

(1 +0.12)^2

6,000

(1 +0.12)^2

8,000

(1 +0.12)

4,000

(1 +0.12)

Solution