Project appraisal techniques Flashcards
Learn about - Appraising the profitability of proposed projects in the context of present value (8 cards)
What is the time value of money? What three things cause it?
Time value of money - A sum of money in the present has greater value than that same sum of money in the future. For example, 500 euro today is worth more than 500 euro in a year’s time.
This is caused by:
1) Inflation
2) Interest
3) Risk
What are discounted cash flows?
Every project proposed by a business will generate cash flows (Revenue or expenses) in the future. These future cash flows need to be adjusted in order to meet the present day value of money.
??What is compound interest and what is discounting? ??
??Compound interest - A lump sum receives a certain amount of interest in fixed time intervals (i.e, in a bank account, a bond etc). This interest accumulates over time causing the value of the initial lumps sum to become much greater than it initially was.
Discounting is the opposite of this. An initial figure is gradually reduced over time??
What is NPV?
NPV - Net Present Value. This is the sum of discounted cash flows that will be produced if a business goes through with a project. It shows the sum of future cash flows from a business after a specific period of time.
How is NPV useful to business when they consider which projects to go through with?
Every project involves an initial investment of money. The NPV can show the sum of future cash flows generated by a project. This figure can be compared to the figure of the initial investment.
If the net present value is equal or greater to the present value of the investment, the business should greenlight.
If the net present value is less than the present value of the investment, the business should reject the proposal.
What is the formula for the net present value?
NPV = F0 + F1/(1+k) + F2/(1+k)² … Fn/(1+k)*
F stand for cash flow
0,1,2… n is the year
K is the rate at whcih the value of the money reduces annually, when compared to present value.
Ex:
A project costs 1000 and generates 300 over 4 years. This would initiallly seem like a good project as 300 (the amount earned every year) times 4 (the number of years the project will be operating) equals 200. This would give the company a 200 profit. However, the value of money will reduce by 8% per year, compared to present value.
-1000 (F0) + 300/(1.08) + 300/(1.08)² + 300/(1.08)³ + 300/(1.08)⁴ = -6.36
Adjusted for present value, the sum for the future cash flows are below the original investment figure of 1000. This makes the proposed project a bad investment decision.
* To the power of n
What are incremental cash flows?
Cash flows that occur because the business agreed to finance a proposed project. These cash flows occur after the project has been agreed upon, so costs that influenced the decision ( i.e, research costs, advisors etc) do not count. These costs are known as sunk costs.
What are sunk costs?
