Investment Appraisal

Mikeyabosbht

Guys,

Regarding net present value questions, what happens if the answer comes out at 0, after multiplying the yearly cash flows by the discount factor? And you have to make a reccommendation to accept or reject?

Thanks.

SandyHood

The zero NPV means the cost of the investment is equal to the present value of the future receipts. The business will not benefit or lose (assuming all the assumptions come true).

Whether you recommend or not depends on other things, but on purely financial grounds there would be no benefit if you invested, so say no.

As it is zero, it means that the discount rate is the same as the internal rate of return.

Mikeyabosbht

Thanks a lot for your reply. It has been really bugging me.

I would be really grateful if I could draw on your expertise further. I have been working my way thorough past exam papers and I recall a question on "Net Present Cost". A term that I am not previously aware of, as no information is present in any of my study books.

Looking in the answers section, the initial outlay is added to the yearly cash flows after multiplying them by the discount factor. What is the purpose of this exercise?

To be honest, I think it is a little sly to put that in the paper.

Pinkjo

I think that it is the opposite of NPV ie how much something is going to cost you as opposed to how much it is worth. You could be comparing paying up front for something or paying in installments.

Mikeyabosbht

Thank you for your reply. It is a highly unusual method though.

SandyHood

Mike

When you evaluate the viability of future investment opportunities you need to carry out the analysis in the context of the department where it will take place.

Profit centres have revenues and costs, so you would try to identify all the future revenues associated with the investment and all the future costs.

Cost centres only have costs, so you would only be able to assess the costs paid and saved.

If a hotel was looking at rebranding a bar then we would look at the life of that new bar, take all the cash flows in and out and discount them by the appropriate year. This would enable us to find the net present value of the whole rebranding investment.

If the same hotel wished to invest in its own laundry then a similar exercise would take place. Instead of the money customers would pay, the project would record the savings that it makes by no longer having to pay a laundry company to collect, wash and return the sheets towels etc. Again this gives a net present value as there are savings and payments associated with the laundry investment.

If we have to make an investment in a garden there may not be any cash coming in at all and no savings either, but the hotel will benefit anyway. The choice then is to look at which method to use for the garden investment.

1. A large initial investment in landscaping followed by maintenance each year over the life of the garden
2. Much less initial investment, but a more expensive cost each year for maintenance

Here you'd be comparing different costs, so the net present cost would be your criterion with the lower being the prefered option.

There are loads of examples, the sales reps cars - do you replace them now by selling them and buying new. Presumably new cars have less maintenance and running costs each year.
Or, do you lease fom a finance company.
Or do you pay them to use their own cars

All have cash outflows and no cash inflows so have to appraised using NPC rather than NPV.

Mikeyabosbht

Sorry for the delay in replying.

Wow, you know too much to just be a level 3 student. Thank you so much for answering my query. I will print it off and add it to my notes.

Rachey

Thankyou Sandy, your post has helped me too. Please never disappear off these forums!