Lecture Notes on Investment Appraisal

Introduction

• Investment appraisal is a significant part of the syllabus and exam, focusing on investments in new machines or projects.
• Decisions involve whether to accept or reject investment in new machinery or projects.
• Choice may also be between two options, deciding which is better.

Methods of Investment Appraisal

1. Discounted Cash Flow (DCF)
   • Most important method discussed.
   • Focuses on calculating the net present value (NPV).

Discounted Cash Flow (DCF)

• DCF considers the time value of money, discounting future cash flows to present value.
• Calculate the NPV by subtracting initial investment from total discounted cash inflows.

Example Calculation

1. Machine cost: $80,000.
2. Expected life: 4 years with a scrap value of $10,000.
3. Net Operating Cash Inflows each year: Year 1 = $20,000, Year 2 = $30,000, Year 3 = $40,000, Year 4 = $10,000 + $10,000 scrap value.
4. Cost of capital: 10%.
5. Calculate present value using discount factors:
   • Year 1: 0.909
   • Year 2: 0.826
   • Year 3: 0.751
   • Year 4: 0.683
6. Net Present Value (NPV) calculation shows a surplus of $6,660, leading to acceptance of the project.

Key Concepts

• Cost of Capital: The interest rate used for discounting future cash flows.
• Present Value Tables: Used to simplify calculation of present values.
• Impact of inflation on cash flow values is not directly considered in NPV calculation.

Reservations and Assumptions

• Accuracy of estimated cash flows and cost of capital.
• Assumption that cash flows occur at the end of the year.
• Consideration of non-financial factors, such as environmental impact.
• Shareholders may prioritize profits over cash flows.

Internal Rate of Return (IRR)

• Definition: The rate of interest where the NPV equals zero.
• Importance in understanding the robustness of the investment decision.
• Calculation involves testing various discount rates to determine at what rate NPV becomes zero.

Conclusion

• Mastery of discounting mechanics is crucial.
• Real challenge is in accurately estimating future cash flows.
• Next lecture will cover calculating NPV at different rates and finding the IRR.