Net Present Value Method Of Investment Appraisal

The payback method is a very easy way to assess whether an investment should be made.

Unfortunately it can give misleading answers when cash is limited and you have to choose.

Suppose you are comparing two investments

Investment A costs £16,000 and will generate £1,000 saving per month for 24 months.

Payback is 16 months (16,000/1000)

Investment B costs £16,000 and will generate £800 saving per month for 36 months

Payback is 20 months (16,000/800)

In payback terms, investment A looks better.

But in terms of total cash generated

Investment A will save £24,000  (24 months at £1000 per month) or after deducting the £15,000 cost, a net saving of £9,000.

Investment B will save £28,800 (36 months at £800 per month) or a net saving of £13,800.

But the business has to wait longer for the money.

This is where the idea of present value comes into play.

If you can earn 5% interest p.a. on your money in a bank deposit account, £1,000 now is worth more than £1,000 in 12 months time.

Why? Because you could put it in the bank and have £1,050 in a year’s time.

£1,000 now or £1,050 in 12 months have the same present value.

Present Values Depend On The Discount Rate

The present value calculation takes future cash flows and turns them into today’s money.

Because interest rates are positive, this means that the future values are discounted and the interest rate is known as the discount rate.

The formula is simple

Present Value = Future Value divided by one plus the discount rate for the period.

£1000 = £1050 / (1 + 0.05) = 1050/1.05

The higher the discount rate, the lower the present value.

If the interest rate was 10%, £1050 in 12 months time would have a lower value than £1,000 now.

£1050 / (1 +0.10) = 1050/1.1 = £954.

What Factors Affect The Discount Rate?

First is the interest rate.

Because the banks make a profit, the rate you can borrow at is much higher than the rate you can invest your surplus cash, it makes a difference on whether cash now will save you interest on bank borrowings or earn you interest on bank deposits.

Second is the risk factor for the future cash flows.

Putting money into a bank is usually very safe and there’s little risk (although the Credit Crunch in 2008 proved that’s not always true).

Giving twelve months credit to a customer who is struggling and short of cash is risky. There might only be an 80% chance of getting the money.

That would push up the discount rate you used dramatically.

There’s a lot of complicated finance theory that helps the professionals make the calculations. It’s not necessary for you to know.

Just the principle, the discount factor to calculate present values needs to increase as risk increases over the future cash flows.

Big companies use a concept called the weighted average cost of capital to reflect the fact that part of the money comes from borrowings and part comes from shareholders equity (the money that belongs to the shareholders).

Borrowed money is cheaper – first the banks get their money first so payments are more certain and second, there is usually tax relief on interest for business loans (this may not be true in your country and I’m not a compliance expert – talk to your accountant or tax expert).

I was told a rule of thumb – the cost of equity should be the cost of debt plus 5%. It depends on many factors but it’s a useful starting point. People need a reward for taking risks with their money.

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