The Npv Rule Is The Best Investment Appraisal Method

Investment decisions are essential for a business as they define the future survival, and growth of the organisation. The main objective of a business being the maximisation of shareholders' wealth. Therefore a firm needs to invest in every project that is worth more than the costs. The Net Present value is the difference between the project's value and its costs. Thus to make shareholders happy, a firm must invest in projects with positive NPVs. We shall start this essay with an explanation of the NPV, then compare this method with other investment appraisal methods and finally try to define, based on the works of Tony Davies, Brian Pain, and Brealey/Myers/Allen, which method works best in order to define a good investments.

So what is the Net Present Value? The NPV is today's value of the difference between cash inflows and outflows projected at future dates. When a firm makes profit it can either reinvest the cash or return it to the investor. If cash is reinvested then it should offer a better rate of return as one that shareholders could have gained by investing in financial assets themselves. Two essential points are to be considered in a good method of investment appraisal. The first one is the fact cash is king (that is the fact, cash as soon as available can be invested in some way or another) and the second is the time value of money (Receipt of Ј100 today has more value than receipt of Ј100 in one year's time). This is due to the fact, first that, the money could have been invested immediately, where you would or could have made a capital gain and, second that, purchasing power is lost every year due to inflation.

The percentage rate by which the money is eroded over one year is called the discount rate. The amount by which the value of say Јx is eroded over one year is calculated by dividing it by what is called the discount factor.

Јx

(1 + discount rate %)

Investment appraisal methods in which a technique of discounting the projected cash flows is used to ascertain its present value are called discounted cash flow methods. The discount rate is defined by each firm, usually based on the cost of capital and the borrowing interest rate.

We thus obtain the following formula.

With: Io: initial investment

I: cash flows

r: discount rate

It is clear that any investment rule that does not recognise the time value of money cannot be sensible. Also, we have shown that NPV depends solely on the forecasted cash flows from the project and the opportunity cost of capital. This investment rule is thus not affected by managers' tastes, the profitability of the company's current businesses, or the profitability of other independent projects. Finally, because present values are calculated in today's pounds then you can add them up. Therefore, if you have two projects A and B, the net present value of the combines investment is NPV(A+B) = NPV(A) + NPV(B). This enables one to avoid accepting a package investment that is not as profitable as a project on its own.

These days 75 percent of companies use the NPV upon making investment decisions. However, NPV is not the only criteria a company may use for making an investment.

Discounted Payback Method

Some companies require that the initial outlay on any project should be recovered within a specific period. The discounted payback appraisal method requires a discount rate to be chosen to calculate the present values of cash inflows and then the payback is the number of years required to repay the initial investment. Yet payback can give misleading answers.

Project Year 0 Year 1 Year 2 Year 3

A -4,000 2,500 500 5,500

B -4,000 2,500 1,800 0

C -4,000 3,180 500 0

The cost of capital is 10% per annum

Project A

Year Net cash Discount factor Present Cumulative

flow at 10% values present values

0 -2,000 1.00 -2,000 -2,000

1 500 0.91 455 -1,545

2 500 0.83 415 -1,130

3 5,000 0.75 3,750 2,620

Project B

Year Net cash Discount factor Present Cumulative

flow at 10% values present values

0 -2,000 1.00 -2,000 -2,000

1 500 0.91 455 -1,545

2 1,800 0.83 1,494 -51

3 0 0.75 0 -51

Project C

Year Net cash Discount factor Present Cumulative

flow at 10% values present values

0 -2,000 1.00 -2,000 -2,000

1 1,800 0.91 1,638 -362

2 500 0.83 415 53

3 0 0.75 0 53

The payback rule does not take into consideration any cash inflow that occurs after the cut-off date. For example if the cut-off date is two years, project A although clearly the most profitable on the long term will be rejected. Thus if a firm uses the same cut-off regardless of project life then it will tend to accept many poor short lived projects and reject many good long lived ones.

Accounting rate of return

The accounting rate of return (ARR) is a simple measure sometimes used in investment appraisal. It is a form of return on capital employed. ARR is calculated in the following way:

ARR= average accounting profit over the project x 100%

Initial investment

We here see that ARR is based on profits rather than cash flows and that it ignores the time value of money. It therefore just gives