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I’m very confuse with the interest payment due with the investment project . I found an answer said it should treat like irrelevant cost since they are accounted in the process of discounting (NPV analysis) . But, I can’t understand why the discount factor is relevant with the interest payment . When talking about the cost of capital , normally is about the opportunity cost or inflation . I’m really can’t found any relationship between them .
Is anybody here can answer mine question ,if can hope it come with example as well (easier to understand with example)
I don’t know why you ask for ‘anybody here’ – this is the Ask the Tutor Forum and so I am the tutor 🙂
That whole purpose of discounting is to account for the interest (it is nothing to do with opportunity costs or inflation – they could be relevant in determining the cash flows, but not for the discounting itself).
Best is for you to watch my free Paper F2 lectures on investment appraisal. They explain why we discount in the first place, and then you can carry on with the F9 lectures,
I thought the discount factor is relevant with the inflation and the time value of money .
Let’s said , an investment is required £1000 and get a return of £1000 after one year . I have been told the discount factor is to measure the different value of money . Assume the market interest rate is 10%. That mean the £1 now, will become £1.1 after a year due with the interest rate . Or the thing you can buy with £1 now , you need to paid £1.1 for the same thing after one year .
So go back to the investment project ,if we judge the investment without any further analysis ,it will be no gain no loss . However, if we take the inflation or the opportunity cost ( the interest we can gain if we deposit the amount rather than invest to this project ) into account , we actually loss because of the opportunity cost and inflation .
The thing I’m really struggle is the interest payment , using the same question before . If the interest payment is also 10% of the amount we invest , is just about £100 for the payment . It quite different with the the discounted amount (£1000 x 0.909 ) .
By using the question for your lecture notes as well , the cost of new project it will cost £80,000 and the interest rate is 10% p.a
I’m really can’t understand why the interest rate is take to discount the operating cashflows .
The interest payment should be £8,000 per year . There is nothing do with the discount of 10% with the operating cashflows .
However , if we take the interest rate as opportunity cost . This will be make sense .
The future value of £1 now is £1.1 , that mean no matter what you get next year will equal to the same value with the initial investment only after discount by 10 % . This is also the way discount factor come from (1/1.1) = 0.909
The thing actually done by the NPV analysis is , it can covert the cashflows back to the same value of the amount you invest in the first place . In short , the money you receive now can’t compare with the same amount in last year.
The discounting is purely to account for the cost of the capital employed in the project.
You could add interest each year to the borrowing in order to calculate the final net surplus or deficit – this would be the net terminal value and if it were positive we accept and if negative we reject. However that is both time consuming and also can make it difficult to compare investments.
So instead we ‘remove’ interest each year by discounting and use the net present value.
Again, you really should watch the Paper F2 lectures on investment appraisal – it is there that I explain the logic behind discounting. In Papers F9 and P4 it is assumed that you are happy with the logic, and therefore the work is being able to deal with more complicated cash flows – the discounting itself never gets harder than F2 and is a minor part of the work, it is arriving at the cash flows that gets more difficult.
There is absolutely no point whatsoever in using the lecture notes without watching the lectures – it is in the lectures that we explain and expand on the notes. If you are not watching the lectures for any reason then you must study using a Study Text from one of the ACCA approved publishers.
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