Investment Appraisal

An assessment of whether capital

expenditure on long-term projects

should be undertaken

Use the NPV method to assess the

financial merits of the project

Net Present Value (NPV)

Calculate the present value of all the

cashflows associated with an

investment

P0 = Ft

(1 + i)t

P0 = Ft

(1 + i)t

t = 1

Net present value is the present

value of all future cashflows, less

time 0 cashflow

Let F become C for cashflow:

NPV = -C0 + Ct

(1 + i)t

t = 1

NPV Method

Determine all the cashflows (inflows

& outflows) for each year

Discount these cashflows to today

using the cost of capital

Accept projects where NPV > 0

Increases investors wealth

Reject projects where NPV < 0

Decreases investors wealth

Conventions

Only project cashflows are

considered

Initial cashflow occurs at time 0

Cashflows are assumed to occur at

the end of the year

Ignore interest payments as the cost

of debt is captured by the discount

rate

Identifying Cashflows

1. Include only incremental cashflows

i.e. those cashflows that arise as a

result of the project

2. Consider the project’s effect on

other areas of the business:

- lost sales

- sales creation

3. Include opportunity costs

4. Include salvage values

5. Ignore sunk costs i.e. costs that have

been committed to but not yet paid

6. Include working capital

requirements (an inflow at the start

of the project and an outflow at the

end of the project)