Financial Context of Business III: Discounting and

Investment Appraisal
The investment decision-making process:
• Managers need to decide where they want to 'take' the business
• What investment decision they make is vital to the success and growth
of the business
• Investment decision making has a number of distinct stages:

Origination of proposals: where many different alternatives are

introduced and discussed.

Project screening: where the 'sensible' projects are looked at with the
company's long-term aims in mind.

Analysis and acceptance: where detailed investment appraisal

techniques/financial analysis are undertaken, together with qualitative issues
being discussed.

Monitor and review: where progress is monitored, comparison to capital

expenditure budgets is made and timing is reviewed.

In this chapter, we will focus on stage 3.

One characteristic of all capital expenditure projects is that cash flows arise
over the long-term (a period usually greater than 12 months). Under this
situation, it becomes necessary to carefully consider the time value of money.

The time value of money:

Money received today is worth more than the same sum received in the
future, i.e. it has a time value.

This occurs for three reasons:

• potential for earning interest/cost of finance
• impact of inflation
• effect of risk.
Discounted cash flow (DCF) techniques take account of this time value of
money when appraising investments.

The time value of money:

Potential for earning interest:

Cash received sooner can be invested to earn interest, so it is better to have $1
now than in one year’s time. This is because $1 now can be invested for the
next year to earn a return, whereas $1 in one year’s time cannot. Another way
of looking at the time value of money is to say that $1 in six years’ time is
worth less than $1 now.

Impact of inflation:
In most countries, in most years prices rise because of inflation. Therefore,
funds received today will buy more than the same amount a year later, as
prices will have risen in the meantime. The funds are subject to a loss of
purchasing power over time.

Risk:
The earlier cash flows are due to be received, the more certain they are – there
is less chance that events will prevent payment. Earlier cash flows are
therefore considered to be more valuable.

Interest:

Simple interest:

One of the most basic uses of mathematics in finance concerns calculations of

interest, the most fundamental of which is simple interest.

With simple interest the interest is paid only on the original principal (i.e. the
original amount borrowed/saved), not on the interest accrued.
 Illustration 1 – Simple interest

Suppose I invest $200 for 3 years at an annual interest rate of 5% and that
interest is calculated by reference to the original sum invested.

How much will I have at the end of the investment?

• The annual interest will be 200 × 5% = $10
• At the end of three years the total interest will be 3 × 10 = $30
• The final sum will thus be $230

Formula:

More generally, suppose $P is invested at a fixed rate of interest of r per

annum (where r is a percentage expressed as a decimal).

The interest earned each year is calculated by multiplying the rate of interest r
by the amount invested, $P, giving an amount $(r × P).

After n years the sum of $(r × P × n) will be credited to give a total at the end of
the period, $V, of: V = P + r × P × n or: V = P(1 + r × n)

This well-known formula is often referred to as the simple interest formula.

Note: this formula can be applied to non-annual time periods as long as an

interest rate is used to match the timescales.
 Illustration 2 – Simple interest:

Suppose I invest $2,000 in a deposit account paying 0.1% per month. Calculate
the final value in the account after two years, assuming simple interest.

P = 2,000
r = 0.001 (remember to express the interest rate as a decimal)
n = 24

V = P(1 + r × n) = 2,000 × (1 + 0.001 × 24) = 2,000 × 1.024 = $2,048

Compound interest:

In practice, simple interest is not used as often as compound interest. With

compound interest, the interest is paid on both the original principal plus any
interest accrued. This means that the interest is calculated on the total balance
brought forward rather than on the initial amount.
 Illustration 3 – Compound interest:

Suppose $200 is invested for 3 years at 5% compound interest – i.e. interest is

added at the end of each year based on the brought forward balance and so
affects the interest for the next year.

For year 1 the interest will be 5% × $200 = $10. The total sum carried forward
will thus be $200 + $10 = $210.

For year 2 the interest will be 5% × $210 = $10.50. The total sum carried
forward will thus be $210 + $10.50 = $220.50.

For year 3 the interest will be 5% × $220.50 = $11.025. The total sum at the
end of the investment will thus be $220.50 + $11.025 = $231.525.

Notice that each year the sum grows by a factor of (1.05). As a short cut we
could calculate the value at the end of year 3 as $200 × (1.05) × (1.05) × (1.05)
= $200 × (1.05)3 = $231.525

Formula:

Suppose $P is invested for n years at a fixed rate of interest of r per annum

compounded annually. After n years the value, $V, will be given by V = P(1 +
r)n, where r is expressed as a decimal

This well-known formula is often referred to as the compound interest

formula.

As you will see, in financial mathematics we work with an annual ratio denoted
by (1 + r) rather than with the rate of interest.
Equivalent rates of interest:

Suppose the rate of interest on a loan was stated to be 8 per cent per annum
with payments made every 6 months. This means that 4 per cent would be
paid every 6 months.

We can find the effective annual rate of interest by considering the impact of
two 4 per cent increases on an initial value of $1:

Value at the end of 1 year = $1 × 1.04 × 1.04 = $1.0816.

$0.0816 has been added on to the initial value of $1, or 8.16% of its original
value.

Hence, the effective annual rate of interest is 8.16 per cent in this case.

Note:
In some respects, quoting the cost of the loan as 8% per annum is misleading
and understates the real effective rate. This is why, in the UK, lenders have to
quote the 'APR' of any loans or financing deals they want you to use, as this
gives the effective annual percentage rate. This is the most useful figure to use
when comparing different financing deals. The same considerations apply to
deposit rates.

Investment appraisal:

Introduction:

Firms often have investment appraisal decisions that involve looking at

forecast cash flows occurring many years into the future. The long-term nature
of such projects raises potential problems when comparing cash flows at
different times.

Consider the following illustration.

 Illustration 4 – Long-term projects:

Suppose you have a very simple project that involves the following:
• Invest $10,000 now
• Based on your best estimates you expect to receive $11,000 in the
future.

Would you accept this project?

Even though it gives you a gain of $1,000 and a return of 10%, the answer is
not clear cut because it depends on when you receive the $11,000 and what
else you could do with the $10,000 now.

Suppose the $11,000 is to be received in 2 years’ time (t2) and that you could
invest your current funds in a deposit account paying interest at 6% per
annum.

If you invest your cash for two years, then in two years’ time you would end up
with $10,000 × 1.06 raise to 2 = $11,236

This is greater than the $11,000 expected through the project, so you would
therefore reject the project and invest the money in the bank instead.

Effectively you are saying that $10,000 now (t0) is worth more to you than
$11,000 in two years’ time (t2), illustrating the concept that money has a time
value.

The time value of money:

The time value of money can be expressed as an annual interest rate for
calculation purposes. Different terminology is used to describe this rate,
depending on the exam paper and the context:
• Discount rate
• Required return
• Cost of capital.

Suppose we have a 'required return rate' of 10% per annum:

• If this related just to a deposit rate at a bank, say, then we could invest
$100 now and end up with $100 × 1.10 = $110 in one year's time.
 • This means that $100 now and $110 in one year's time have the same
value to us for decision-making purposes when assessing other potential
projects.
• Equivalently, we could say that the offer of $110 in a year's time is only
worth $110/1.10 = $100 in today's terms (or 90.9% of its actual value).

Discounted cash flows:

In a potential investment project, cash flows will arise at many different points
in time. To make a useful comparison of the different flows, they must all be
converted to a common point in time, usually the present day, i.e. the cash
flows are discounted.

The process of converting future cash flows into present values is known as
"discounting" and is effectively the opposite of compounding interest.
 Illustration 5 – Discounting

Find the present value of:

(a) $200 payable in 2 years’ time, assuming that an investment rate of 7 per
cent per annum, compounded annually, is available

(b) $350 receivable in 3 years’ time, assuming that an annually compounded

investment rate of 6 per cent per annum, is available.

Solution:

(a) From the definition, we need to find that sum of money that would have
to be invested at 7 per cent per annum and have value $200 in 2 years’ time.
Suppose this is $P, then the compound interest

formula gives: V = P(1 + r)^n

Thus: $200 = P(1 + 0.07)^2

P= $200(1.1449) =$174.69

Thus, the present value is $174.69: that is, with an interest rate of 7 per cent,
there is no difference between paying $174.69 now and paying $200 in 2 years’
time.

(b) Using the compound interest formula again:

$350 = P(1 + 0.06)

$P= $350(1.191016) = $293.87
The present value is thus $293.87.
Discounting a single sum:

The present value (PV) is the cash equivalent now of money

receivable/payable at some future date.

The PV of a future sum can be calculated using the formula:

P=V×(1+r)^–n

This is just a re-arrangement of the formula we used for compounding.

Net present value (NPV):

In many situations, there are a number of financial inflows and outflows

involved, at a variety of times. In such cases, the net present value (NPV) is the
total of the individual present values, after discounting each, as above.

The NPV represents the net gain or loss on the project after taking into account
the timing of cash flows and the time value of money (i.e. incorporates the cost
of finance, investment opportunities, inflation and risk), therefore:

• if the NPV is positive – the project is financially viable

• if the NPV is zero – the project breaks even
• if the NPV is negative – the project is not financially viable
• if the company has two or more mutually exclusive projects under
consideration it should choose the one with the highest NPV
• the NPV gives the impact of the project on shareholder wealth.
Problems using NPV in practice:

One of the major difficulties with present values is the estimation of the
‘interest rates’ used in the calculations.

Clearly, the appropriate rate(s) at the start of the time period under
consideration will be known, but future values can be only estimates. As the
point in time moves further and further into the future, the rates become
more and more speculative.

Many situations in which NPV might be involved are concerned with capital
investments, with the capital needing to be raised from the market.

For this reason, the ‘interest rate(s)’ are referred to as the cost of capital, since
they reflect the rate(s) at which the capital market is willing to provide the
necessary money.
Another problem with calculating net present value is the need to estimate
annual cash flows, particularly those that are several years in the future, and
the fact that the method cannot easily take on board the attachment of
probabilities to different estimates.

Finally, it is a usual, although not an indispensable, part of the method to

assume that all cash flows occur at the end of the year, and this too is a
potential source of errors.

With easy access to computers, it is now possible to calculate a whole range of

NPVs corresponding to worst-case and best-case scenarios as well as those
expected, so to some extent some of the problems mentioned above can be
lessened.

Annuities:

An annuity is an arrangement by which a person receives a series of constant

annual amounts. The length of time during which the annuity is paid can either
be until the death of the recipient or for a guaranteed minimum term of years,
irrespective of whether the annuitant is alive or not. In other types of annuity,
the payments are deferred until sometime in the future, such as the
retirement of the annuitant.

When two or more annuities are being compared, they can cover different
time periods and so their net present values become relevant. In your exam,
you will be given the following formula for the NPV of a $1 annuity over n
years at interest rate r, with the first payment 1 year after purchase.

Annuity factor = 1 – (1+r)^ -n

To calculate the present value of an annuity cash flow:

PV = future cash flow × annuity factor

There is also a cumulative present value table available in the exam where you
can look up values of the annuity factor for whole r values between 1% and
20% and whole years between 1 and 20.
Perpetuities:

Finally, there is the concept of perpetuity. As the name implies, this is the same
as an annuity except that payments go on forever. it is therefore of interest to
those who wish to ensure continuing payments to their descendants, or to
some good cause. It must be recognised, however, that constant payments
tend to have ever-decreasing value, owing to the effects of inflation and so
some alternative means of providing for the future may be preferred.

To calculate the present value of a perpetuity cash flow:

PV = future cash flow × perpetuity factor.

Perpetuity factor = 1/r

This factor is not available on tables but is simple to calculate.

Internal rate of return:

We have seen that if the NPV is positive, then it means that the project is more
profitable than investing at the discount rate, whereas if it is negative, then the
project is less profitable than a simple investment at the discount rate.

For most projects, the NPV falls as the discount rate increases. When the NPV
becomes zero we have a breakeven discount rate, defined as the internal rate
of return (IRR) of the project.

This now gives us two ways of appraising an investment:

1: Accept if NPV > 0 as this means the project will increase shareholder wealth
2: Accept if actual discount rate < project IRR, as this means we should have a
positive NPV.

Calculating IRR:

The internal rate of return (IRR) is the discount rate at which the NPV
is zero. It is obtained generally by a trial-and-error method as follows:
1: find a discount rate at which the NPV is small and positive
2: find another (larger) discount rate at which the NPV is small and negative
3: use linear interpolation between the two to find the point at which the NPV
is zero.
Terminal values and sinking funds:

Instead of being asked to calculate a present value for a series of cash flows
spread over many different time periods, you may be asked to calculate a
terminal value.

This simply means that instead of discounting all the cash flows to the present
day and adding them up they should all be compounded to the end of the
project and added up

A sinking fund is a special type of investment in which a constant amount is

invested each year, usually with a view to reaching a specified value at a given
point in the future. Questions need to be read carefully in order to be clear
about exactly when the first and last instalments are paid.