BUSF_A01.qxd

Chapter 4 • Investment appraisal methods

to do so. Indeed, it could even do this to raise the finance with which to make the

£10 million investment (assuming that the present value of the £12 million is greater

than £10 million).

The next question is: what is the present value of £12 million receivable after one

year with an interest rate of 10 per cent p.a.?

If we let the amount that could be borrowed (the present value of £12 million in a

year’s time) be B, then:

£12m =B+ B×

which represents the borrowing plus the interest for one year. This can be re-

written as:

£12m=B 1 +=B×1.10

B=

=£10.9m

If we now compare the present value of the future receipt with the initial invest-

ment, the result is an investment with a net present value(NPV) of £0.9 million

(that is, £10.9 million – £10 million). Since this is positive, the investment should be

undertaken assuming that there is not a mutually exclusive alternative with a higher

positive NPV.

The £0.9 million NPV tells us that the business can invest £10 million immediately

to gain a benefit whose present value is £10.9 million, that is, a £0.9 million increase

in the value of the business. In principle, the business could borrow £10.9 million, use

£10 million to make the investment and immediately pay out the £0.9 million to the

shareholders as a dividend. When the £12 million is received, it will exactly pay off

the £10.9 million plus the interest on it.

More generally, we can say that the NPV of an investment opportunity lasting for

one year is:

NPV =C 0 +

where C 0 is the cash flow immediately (time 0) (usually negative, that is, an outflow of

cash), C 1 is the cash flow after one year and ris the interest rate.

In practice we tend to use the NPV approach (that is, discountingfuture cash flows)

for investment decision making rather than the net future value approach (compound-

ingpresent cash flows), though in essence neither is superior to the other.

The reasons for favouring NPV are twofold:

l When comparing investment opportunities (choosing between one and the other),

if net future value is to be used, a decision must be made on when in the future the

value should be assessed (that is, for how many years value should be com-

pounded). If the competing opportunities are of unequal length (say, one lasts three

years, the other five years), this can cause difficulties.

l If the opportunity is to be assessed by looking at its effect on the value of the busi-

ness, it seems more logical to look at the present effect rather than the future effect.

C 1

1 +r

£12m

1.10

D

F

10

100

A

C

D

F

10

100

A

C

‘