LEVEL 6: FINANCIAL MANAGEMENT
Investment Appraisal using DCF methods:
- Discounted cash flow;
- NPV;
Hadeel Cassinelli
This is an absolutely critical topic as
questions requiring the use of NPV will come
up frequently in the end-of-year final exam.
Lesson objectives:
Discounted cash flow (DCF) techniques
By the end of this lesson, students will be able to:
a) Explain and apply concepts relating to interest
and discounting, including:
i) the calculation of present values, including the
present value of an annuity and perpetuity, and
the use of discount and annuity tables;
ii) the time value of money and the role of cost of
capital in appraising investments.
b) Calculate net present value and discuss its
usefulness as an investment appraisal method.
Time value
Cash received in one year’s time is not
worth the same as cash received today
Future cash flows need to be discounted
Revision - Time value
Money has a time value – i.e. the timing of a cash flow affects
how much it is really worth to us.
For example, if offered £100 now or £100 in one year’s time,
most people would choose the money now.
The main reasons for this time value are as follows:
• Inflation – time erodes the purchasing power of the money.
• Investment opportunities – the money now can be invested to grow
into more than £100 in one year.
• Cost of finance – the receipt now could be used to repay a loan, say,
and save/ reduce interest charges.
• Risk – the earlier cash flow is less risky than the promise of cash in
the future.
Basic idea
£1,000 now £ 1,000 later
Present Value x (1+ 0.1) = Terminal Value
£100 £ 110
Compounding
Discounting
x 1
(1+ 0.1)
Compounding & Discounting
• Compounding = multiplying a present sum
by a return % to give a future value of an
investment,
i.e. FV = PV (1 + r)n
• Discounting = dividing the future value of
an investment by a return % to give the
present value,
i.e. PV = FV 1
(1 + r)n
Present value
If the discounted future cash flows >
cost of setting up the project today
The project has a + net present value (NPV)
Decision: If NPV is POSITIVE,
the project will be accepted as it
increases shareholder wealth;
If NEGATIVE NPV, it would be
rejected on financial grounds.
Annuities
Annuity: Formula:
• A constant cash flow PV: 1 – (1+r) –n
for a number of r
years
Q: Calculate 12% discount factors for years 1 – 3
3 calculation methods:
(1) Present value is calculated by ADDING together the
discount factors for the individual years:
= 0.893 (t1) + 0.797 (t2) + 0.712 (t3) = 2.402
(2) Use formula above: PV = 1 – (1.12)-3/0.12 = 2.402 (to 3 dp)
(3)Use Annuity tables: look up 12% column and row for year 3
= 2.402 (easiest method).
Perpetuities
Perpetuity: Formula:
• An annuity which PV: 1
goes on forever r
Q: What is PV of £1 per annum in
perpetuity at a discount rate of:
(i) 10%
(ii) 15%
(iii) 20%
Lecture 2: NPV question practice
Class work through NPV
handout together (on
Moodle) to illustrate
various NPV scenarios.
W1+2 Seminar - NPV
KNUCKLE DOWN (in Question Bank)
• Please attempt & review
before coming to seminar.
• Prior reading will benefit
you greatly!
Homework
Please attempt Multiple Choice questions
on Moodle to ensure you are comfortable
with the NPV Investment Appraisal
method – we will be studying more
complicated scenarios in future weeks so
a good understanding of the basics is
essential. This only comes with continuous
question practice.