Net Present Value (NPR) (DP IB Business Management)
Revision Note
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
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
(2)
Step 2: Add together the discounted cash flow values for each year, including Year 0
(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 |
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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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