You have studied investment appraisal previously so most of this chapter will be revision for you. Of the few new items in this chapter, the most important is Modified Internal Rate of Return and you should make sure that you learn the technique involved.
Net present value calculations
Here is a list of the main points to remember when performing a net present value calculation. After we will look at a full example containing all the points.
- Remember it is cash flows that you are considering, and only cash flows. Non-cash items (such as depreciation) are irrelevant.
It is only future cash flows that you are interested in. Any amounts already spent (such as market research already done) are sunk costs and are irrelevant.
- There is very likely to be inflation in the question, in which case the cash flows should be adjusted in your schedule in order to calculate the actual expected cash flows. The actual cash flows should be discounted at the actual cost of capital (the money, or nominal rate). (Note: alternatively, it is possible to discount the cash flows ignoring inflation at the cost of capital ignoring inflation (the real rate). We will remind you of this later in this chapter, but it is much less likely to be relevant in the examination.)
- There is also very likely to be taxation in the question. Tax is a cash flow and needs bringing into your schedule. It is usually easier to deal with tax in two stages – to calculate the tax payable on the operating cash flows (ignoring capital allowances) and then to calculate separately the tax saving on the capital allowances.
- You are often told that cash is needed to finance additional working capital necessary for the project. These are cash flows in your schedule, but they have no tax effects and, unless told otherwise, you assume that the total cash paid out is received back at the end of the project.