Discounted Cash Flow (DCF) methods

　　The Net Present Value (NPV) and Internal Rate of Return (IRR) are the two investment appraisal methods under DCF. Let us now describe and comment upon the two methods.

　　Net Present Value (NPV) Method

　　Of all the investment appraisal methods, NPV is often argued to be the most superior. This is because it takes into account the time value of money. The method assumes that a pound today is worth more than a pound this time next year. It works under the assumption that if one is owed a pound and the borrower offers a choice of either giving the pound now or in a year?s time, the more rational option for the lender is to take the pound now. Provided the lender does not keep the pound under his mattress at home, it will be worth more than a pound in a year?s time. The reverse is true if the borrower has the option to pay either now or in a year?s time, the borrower would choose to pay in the future as the pound he/she pays in the future will be worth less than what he/she would have paid now. It stresses that future cash flows should be expressed in terms of what they are worth now when cash is expended on the project. The present values of these future cash flows can then be compared with what we are spending now on the project. In other words, the NPV is saying that one should compare like with like, which of course is a fair statement. By setting the future cash inflows from the project without discounting them against the initial capital cost, one is not being realistic and fair.

　　When present values of cash outflows and inflows are compared, if the result gives a positive NPV, then the project should be recommended. In a mutually exclusive situation, that is, when you can only undertake one project and not two projects at the same time, if two projects were to give positive NPVs, then the project with the higher NPV is the one to recommend.

　　When using the NPV method the present value table is required in order to find out the present value factors of the pound at different rates over different time periods. Your examination question paper has often in the past provided the table for candidates? use with the examination questions. There is no indication that this will not continue. However the figures in the table can be calculated if a table is unavailable.

　　Deluxe model

　　Under the NPV method super has a positive NPV of ￡51,840 whilst deluxe has a negative NPV of ￡41,040. Any project with a negative NPV should not be undertaken at all. On the basis of this super model will be recommended but not deluxe model.

　　Internal Rate of Return (IRR)

　　Under NPV we have used 12% discount rate and arrived at both a positive and negative NPV respectively for the two machines. We need to use a higher rate for the Super model to arrive at a negative NPV and a lower rate for Deluxe model to arrive at a positive NPV. Remember that the higher the IRR the better. Let us now use 20% for Super model and 4% for Deluxe model.

　　Super Model

　　Now that we have a negative NPV for Super model we can now use the IRR formula we had earlier to establish IRR for this model.

　　Now let us turn our attention to the second machine, but first we need to find a positive NPV for this machine. We have stated earlier that we will use 4%, let us use that straight away.

　　Deluxe Model

　　The Deluxe module has an IRR of 10.51%. As this is lower than the super model?s 16.52%, once again super model will be recommended.

　　Conclusion

　　It can be seen that all four methods of investment appraisal have consistently recommended the Super model. This has happened because the example was designed to do so. A real life exercise on investment appraisal will probably not be as easy and straightforward as this. Life is never straightforward. The author has not introduced any complications into the example. Areas that could bring in complications such as projects with unequal lives, effects of taxation and inflation have been deliberately left out of the example in this article. A future article by the author will bring in some of these complications so that readers can appreciate that life in this area is not always as straightforward as depicted in this article.