Chapter 4 • Investment appraisal methods
Net present value (NPV )
lNPV =the sum of the discounted values of the cash flows from the investment.
lMoney has a time value.
lDecision rule: All positive NPV investments enhance shareholders’ wealth; the
greater the NPV, the greater the enhancement and the more desirable the project.
lPV of a cash flow (Cn) =Cn/(1 +r)n, assuming a constant interest rate.
lThe act of discounting brings cash flows at different points in time to a
common valuation basis (their present value), which enables them to be dir-
ectly compared.
lConclusions on NPV:
lRelates directly to shareholders’ wealth objective.
lTakes account of the timing of cash flows.
lTakes all relevant information into account.
lProvides clear signals and practical to use.Internal rate of return (IRR)
lIRR =the discount rate that causes a project to have a zero NPV.
lIt 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.
lDecision rule: Projects that have an IRR greater than the cost of financing them
are acceptable; the greater the IRR, the more desirable the project.
lUsually cannot be calculated directly; a trial and error approach is usually
necessary.
lConclusions on IRR:
lIt 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.
lTakes account of the timing of cash flows.
lTakes all relevant information into account.
lDoes 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.
lInferior to NPV.Payback period (PBP)
lPBP =the length of time that it takes the cash outflow for the initial investment
to be repaid out of resulting cash inflows.
lDecision rule: Projects with a PBP up to defined maximum period are accept-
able; the shorter the PBP, the more desirable the project.
lCan be refined a little by using discounted future inflows to derive a dis-
counted PBP.