Having determined the discount rate the process of

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Unformatted text preview: a practice that is not encouraged by many theorists since it does not explicitly consider the varying levels of risk between competing investment options (for a full discussion see Newendorp, 1996 pp307-308). Having determined the discount rate, the process of discounting future sums of money is very straightforward. If the discount rate is equal to i NPV, the net cash flow of year k is equal to CFk and the project life is equal to n years, the NPV is given by (Ross, 1997 p40): n NPV = ∑CFi [1/(1+inpv)i] 77 i=1 If the NPV is positive, the required rate of return will be earned and the project should be considered (the size of the NPV is often used to choose between projects that all have a positive NPV). If NPV is negative, the project should be rejected. Table 5.1 provides an example of DCF analysis. It shows that at a 10% discount rate, the value of a $2000 net cash flow ($2500 of revenues less $500 of operating expenses) that is received in year 5 is worth $1242 now. If $5000 is invested today the total NPV (that is the sum of all the discounted net cash flows) is $2582. In other words; the $5000 is recovered, plus a 10% return, plus $2582. If the $5000 had been invested in a bank at 10% interest, an investor would have been $2582 worse off than he would have been by investing in this project (Bailey et al., in press). YEAR REVENUE OPERATING NET 10% 20% EXPENDITURE CASH DISCOUNTED DISCOUNTED FLOW 0 INVESTMENT CASH FLOW CASH FLOW $-5000 $-5000 $-5000 $5000 1 $2500 $500 $2000 $1818 $1667 2 $2500 $500 $2000 $1653 $1389 3 $2500 $500 $2000 $1503 $1157 4 $2500 $500 $2000 $1366 $965 $1242 $2582 $804 $982 5 $2500 $500 $2000 $5000 $12,500 $2500 $5000 Table 5.1: Discounted cash flow concept (source: Bailey et al., in press) TOTAL Most of the companies that use NPV as their principal “no risk” profit indicator in investment appraisal decision-making do so in conjunction with a sensitivity analysis (Newendorp, 1996). Once they have generated the NPV for a particular investment project, sensitivity analysis is used as a mechanism for investigating whether the decision to invest would change as the assumptions underlying the analysis are varied. Sensitivity analysis can involve varying one, two, or all the parameters’ values simultaneously (Newendorp, 1996). Spider diagrams are commonly used to present the results of a sensitivity analysis with the sensitivity of the NPV to each factor, reflected by the slope of the sensitivity line (figure 5.3). As the curve for a variable becomes steeper, then changes in this parameter will result in large changes of the dependent variable. As the curve becomes flatter, the implication is that changes in 78 the value of the parameter cause very little change in the dependent variable (Newendorp, 1996 pp660-662). Sensitivity analysis is simple to use and it allows the analyst to focus on particular estimates. However, it does not evaluate risk and interrelated variables are often analysed in isolation giving misleading results (Atrill, 2000 p165). While NPV is widely used, it has sev...
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This document was uploaded on 03/30/2014.

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