Accounting for Managers: Interpreting accounting information for decision-making

STRATEGIC INVESTMENT DECISIONS 187

net present value (NPV)=present value of future cash

flows−initial capital investment

The discount rates to be applied are based on the company’s cost of capital.
The cost of capital (see Chapter 2) represents the weighted average of the cost of
debt and equity and takes into account the riskiness of a project. As the cost of
borrowing has been taken into account, an investment makes sense if the NPV
is positive. The discount rate can be obtained from net present value tables (see
Appendix to this chapter for an example). More commonly, spreadsheet software
(e.g. Excel or Lotus) is used as this contains an NPV function.
Using the same example, the NPV for Project 1 is shown in Table 12.6. As the
net present value is negative, Project 1 should not be accepted since the present
value of future cash flows does not cover the initial investment.
The NPV for Project 2 is shown in Table 12.7. Project 2 can be accepted because
it has a positive net present value. However, we need to compare this with Project
3 to see if that alternative yields a higher net present value. The NPV for Project 3
is shown in Table 12.8.
Despite the faster payback for Project 3, the application of the net present value
technique to the timing of the cash flows reveals that the net present value of
Project 3 is lower than that for Project 2, and therefore Project 2 – which also
showed the highest accounting rate of return – is the recommended investment.
However, using the NPV method it is difficult to determine how much better
Project 2 (with an NPV of £7,650) is than Project 3 (with an NPV of £3,300) because
each has a different initial investment.
One way of ranking projects with different NPVs iscash value added(CVA) or
profitability index, which is a ratio of the NPV to the initial capital investment:

cash value added=

NPV

initial capital investment

In the above example, Project 2 returns a CVA of 6.12% (7,650/125,000) while
Project 3 returns a CVA of 1.165% (3,300/200,000). Companies may have a target

Table 12.6 NPV for Project 1

Year Project 1

cash flows

Discount factor

(10%)

Present value of

cash flows

1 25,000 .909 22,725

2 25,000 .826 20,650

3 25,000 .751 18,775

4 25,000 .683 17,075

5 25,000 .621 15,525

Total 94,750

Less: Initial investment 100,000

Net present value −5,250