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IBBusinessDPBusiness ManagementHLRevision Notes3. Finance & Accounts3.8 Investment AppraisalNet Present Value (NPR)

Net Present Value (NPR) (DP IB Business Management)

Revision Note

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

Using the Net Present Value (NPV)

  • The Net Present Value (NPV) takes into account the effects of interest rates and time

  • It recognises

    • The fact that that money received in the future is often worth less than money received today (inflation)

    • The opportunity cost of not having the money available for other uses

  • To calculate the Net Present Value of an investment, the value of all future net cash flows in today’s terms need to be calculated first and then discounted using a table

  • The cost of the initial investment is deducted from the total of the discounted net cash flows

    • If future net cash flows minus the initial investment are positive, then the investment is likely to be worthwhile

    • If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile

  • Discounted cash flows are calculated using discount tables, which allow future cash flows to be expressed in today’s terms
     

Table: discount factors at different rates of interest

ibdp-business-management-discount-table

Worked Example

Brownsea Sightseeing Tours Ltd is considering purchasing a new pleasure craft at a cost of £325,000.  It expects the investment to achieve the following net cash flows over five years of operation

Year

Net cash Flow (£)

10% Discount Factor (2dp)

0

(325,000)

1.00

1

110,000

0.91

2

90,000

0.83

3

75,000

0.75

4

65,000

0.68

5

60,000

0.62

Using the 10% discount factor calculate the NPV of the leisure craft investment. (4 marks)

Step 1 - Calculate the discounted cash flow for each year by multiplying the net cash flow by the discount factor

3-3-2-net-present-value-of-discounted-cash-flow

(2)

Step 2: Add together the discounted cash flow values for each year, including Year 0   

open parentheses £ 325 comma 000 close parentheses space plus space £ 100 comma 100 space plus space £ 74 comma 400 space £ 56 comma 250 space plus space £ 44 comma 200 space plus space £ 37 comma 200 equals space left parenthesis £ 12 comma 550 right parenthesis       

(1)

The Net present Value of the investment is -£12,550

This negative outcome suggests that the investment in the new pleasure craft is not financially worthwhile         

(1)

 
Advantages and Disadvantages of the Net Present Value Method

Advantages

Disadvantages

  • Considers the opportunity cost of money

  • Discount tables are used to calculate forecast future values of net cashflows

  • Businesses may choose different discount tables (20%, 10%, 5% etc)  to adjust the level of risk involved in a project

    • Can consider a range of scenarios

  • More complicated to calculate and interpret than other methods

  • Accurately forecasting future cash flows is complex

  • Choosing an appropriate discount rate can be 'hit and miss'

  • Ignores non-financial benefits or costs e.g. environmental damage

Examiner Tips and Tricks

Being able to calculate the payback period, ARR or NPV of an investment is a key quantitative skill

More important, though, is interpreting the outcome of your calculation and using it to make a judgement

  • Is an investment worthwhile?

  • Which investment is the most profitable?

  • The costs of which investment will be recouped first?

Qualitative factors should be considered alongside calculations - review case study material carefully to select relevant information

Limitations of using Investment Appraisal

  • Each techniques relies upon forecasted future cash flows, which may lack accuracy

    • Managers may lack experience or may be biased towards a particular investment

    • Incomplete past data may make forecasting imprecise or mean that confidence in the data is limited

  • Longer-term forecasts used to predict returns on investments may be inaccurate for a variety of reasons

    • Unexpected increases in costs

    • The arrival of new competitors

    • Changes in consumer tastes

    • Uncertainties arising as a result of economic growth or recession

  • Non-financial factors are ignored

    • Business finances and availability of external finance to fund the investment

    • Overall corporate objectives 

    • Potential for positive public relations or meeting social responsibilities

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    Author
    Reviewer
    Lisa Eades

    Author: Lisa Eades

    Expertise: Business Content Creator

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.