Chapter 4

Business Finance
Learning Roadmap
 Pay back period

Net present Value

Accounting rate of
return

Investment Decision

Internal rate of return

Time Value of Money

Learning Objectives
Learning Objectives

● the importance of the investment decision

● the derivation of the concept of net present value

● an explanation of the meaning of net present value

● a consideration of the other approaches used to

assess investment projects

● a consideration of some recent research bearing

on the investment appraisal techniques used by
businesses in the UK and elsewhere in the world
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 Topic 1
Investment Decision
Investment
• Spend money now with the hope of getting
back more in the longer term
• Improve shareholders wealth from company

Points for consideration:

• How much is needed to get back to justify the
amount invested?
• How quickly does the money need to come
back?
• How sure are you that the benefits will be
achieved? Risk and uncertainty
Profit and cash flow
• Profits are measured in accordance with accounting
rules of accruals
• Depreciation is included as an expense in profit
calculation
• Depreciation does not include cash movement
• Cash flow is the difference between cash receipts
and payments
 Topic 2
Time Value of Money
Time value of money

• Receipt of £100 today is worth more than receipt of £100 in a

year’s time

• 2 reasons
• Today’s money can be invested to earn interest

• Inflation means value of next year’s money will be lower as

purchasing power declines
Discounting cash flows
• Bringing a future cash amount into the value at
the present time
• Cost of capital is used to deduce discount
factors

• Discounted methods
• Net Present Value
• Internal rate of return
Time Line of Cash Flows
•Tick marks at ends of periods
• Time 0 is today;
• Time 1 is the end of Period 1
0 1 2 3
r%

CF0 CF1 CF2 CF3

+CF = Cash INFLOW -CF = Cash OUTFLOW PMT = Constant CF
Present Values
FV = PV(1 + r)t
• Rearrange to solve for PV

PV = FV / (1+r)t
PV = FV(1+r)-t

• “Discounting” = finding the present value of one

or more future amounts.
What’s the PV of $100 due in 3 Years if r = 10%?
Finding PVs is discounting, and it’s
the reverse of compounding.
0 1 2 3
10%

PV = ? 100
Formula: PV = FV(1+r)-t = 100(1.10)-3 = $75.13
Calculator: 3 N 10 I/Y 0 PMT 100 FV
CPT PV = -75.13
Excel: =PV(.10,3,0,100) = -75.13
Present value discount factors
 Topic 3
Net Present Value
Net present value (NPV)

• NPV = the sum of the discounted values of the cash flows from the
investment.
• Money has a time value.
• Decision rule: All positive NPV investments enhance shareholders’
wealth; the greater the NPV, the greater the enhancement and the
more desirable the project.
• PV of a cash flow (Cn) = Cn /(1 + r)n, assuming a constant interest
rate.

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 NPV ( NET PRESENT VALUE METHOD)
• CASH FLOWS* DISCOUNT FACTOR PRODUCES THE PRESENT
VALUE OF A FUTURE SUM OF MONEY

• NPV= PV INFLOWS –PV OUTFLOWS

• ACCEPT A PROJECT IF NPV IS POSITIVE
• SELECT PROJECT WITH THE HIGHEST NPV
• REJECT PROJECTS WITH NEGATIVE NPV
EXAMPLE
Example 4.1 (1 of 2)

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Example 4.1 (2 of 2)

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Net present value (NPV)

• The act of discounting brings cash flows at different points in time

to a common valuation basis (their present value), which enables
them to be directly compared.
• Conclusions on NPV:
• Relates directly to shareholders’ wealth objective.
• Takes account of the timing of cash flows.
• Takes all relevant information into account.
• Provides clear signals and is practical to use.

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 EVALUATION OF NPV

• USES THE TIME VALUE OF MONEY OVER THE WHOLE LIFE OF

INVESTMENT
• ASSESSES WHETHER THE PROJECT WILL EARN A RETURN AT THE
MINIMUM HURDLE RATE
• SHOWS EXCESS OR DEFICIENCY OF INVESTMENT’S PRESENT VALUE OF
NET CASH FLOWS OVER ITS INITIAL COST
• THEORETICALLY SUPERIOR METHOD
 Topic 4
Internal rate of Return
Internal rate of return (IRR) (1 of 2)

• IRR = the discount rate that causes a project to have a zero NPV.
• It represents the average percentage return on the investment,
taking account of the fact that cash may be flowing in and out of the
project at various points in its life.
• Decision rule: projects that have an IRR greater than the cost of
financing them are acceptable; the greater the IRR than the Cost of
Finance, the more desirable the project.
• Usually cannot be calculated directly; a trial and error approach is
usually necessary.

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Internal rate of return (IRR) (2 of 2)

• Conclusions on IRR:

• It does not relate directly to shareholders’ wealth. Usually it will give the same
signals as NPV, but it can mislead where there are competing projects of
different scales.
• Takes account of the timing of cash flows.

• Takes all relevant information into account.

• Does not always provide clear signals and can be impractical to use.

• Often cannot cope with varying costs of finance.

• With unconventional cash flows, problems of multiple or no IRR.

• Inferior to NPV.
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Example 4.4

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Example 4.4

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Example 4.4

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Figure 4.2 Graph of the NPV against the discount
rate for Project C

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Figure 4.2 Graph of the NPV against the discount
rate for Project C

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Figure 4.3 Graph of the NPV against the discount
rate for Project D

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 Topic 5
Pay-back Period
Payback period
The idea is to calculate the length of time
expected to be necessary to recover the
initial project outlay (the investment cost).

Because it is based on cash flows, if the

information about the projects is presented
in terms of expected profits (or losses),
these figures must be adjusted to represent
the expected cash flows instead
Payback period (PBP) (1 of 2)

• PBP = the length of time that it takes the cash outflow for the initial
investment to be repaid out of resulting cash inflows.
• Decision rule: projects with a PBP up to defined maximum period
are acceptable; the shorter the PBP, the more desirable the project.
• Can be refined a little by using discounted future inflows to derive
a discounted PBP.

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Assumptions of payback period
1. Projects are indivisible. This means that it is not possible to
invest, say, one-third of your money in one project, and two-
thirds in another. The business must invest the full amount
required for each project, or none at all.
2. Projects cannot be delayed. This means that once it has been
decided not to invest in a particular project, the opportunity
does not reappear at a later date.
3. Projects cannot be abandoned. This means that it is not
possible to stop a project once it has started, and the project
must be continued to its end.
4. Profits, losses and cash flows arise evenly throughout time
(usually on an annual basis).
Payback period (PBP) (2 of 2)

• Conclusions on PBP:
• It does not relate to shareholders’ wealth; ignores inflows after the payback
date.
• The undiscounted version takes little account of the timing of cash flows.
• Ignores much relevant information.
• Does not always provide clear signals and can be impractical to use.
• Much inferior to NPV, but it is easy to understand and can offer a liquidity
insight, which might be the reason for its widespread use.

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Figure 4.4 Payback period for the Zenith
machine

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1. PAYBACK PERIOD IS SIMPLE AND EASY TO
UNDERSTAND.
2. IT IS PARTICULARLY USEFUL IN SITUATIONS WHERE
BUSINESSES ARE ‘CASH CONSTRAINED’ FOR A
NUMBER OF YEARS – IN OTHER WORDS, WHERE
BUSINESSES HAVE ONLY A LIMITED AMOUNT OF
CASH TO INVEST AND NEED TO RECOVER THEIR
INVESTMENT AS QUICKLY AS POSSIBLE IN ORDER TO
INVEST IN ADDITIONAL PROJECTS.
3. IT IS ALSO BASED ON CASH FLOWS, SO IT DOES NOT
INCLUDE IRRELEVANT COSTS SUCH AS DEPRECIATION.
1. DOES NOT PROVIDE AN ABSOLUTE MEASURE WHICH
MEANS THAT IT IS NECESSARY TO COMPARE ONE PAYBACK
PERIOD TO ANOTHER IN ORDER TO MAKE A DECISION (IN
ISOLATION, THERE IS NO WAY TO KNOW IF A PAYBACK
PERIOD OF 3.5 YEARS IS ‘GOOD’ OR ‘BAD’)
2. IGNORES THE ABSOLUTE SIZE OF THE INVESTMENT OUTLAY
AND SUBSEQUENT CASH FLOWS
3. IGNORES THE SIZE AND DIRECTION OF CASH FLOWS
OCCURRING AFTER THE PAYBACK PERIOD.
4. IT DOES NOT TAKE ACCOUNT OF THE ‘TIME VALUE’ OF
MONEY.
 Topic 6
Accounting rate of return
Accounting rate of return

• The second investment appraisal method that is commonly

used is the Accounting Rate of Return (ARR). It is
sometimes referred to as a Return on Investment (ROI),
and it is essentially the same idea as the Return on Capital
Employed (ROCE) ratio which you met in Chapter 3

• It is the ratio of the average annual profit of the project, to

the investment in the project. Because it is based on the
expected accounting profit of the project there is no need to
adjust for depreciation or other non-cash flows.
Accounting rate of return (ARR) (1 of 2)

• ARR = the average accounting profit from the project expressed as

a percentage of the average (or initial) investment. The
denominator needs to be defined and the definition consistently
applied.
• Decision rule: projects with an ARR above a defined minimum are
acceptable; the greater the ARR, the more desirable the project.

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 ARR CALCULATION

1. TO CALCULATE BASED ON THE INITIAL INVESTMENT

AVERAGE ANNUAL PROFIT = ARR
AMOUNT INITIALLY INVESTED

2. TO CALCULATE BASED ON THE AVERAGE INVESTMENT

AVERAGE ANNUAL PROFIT = ARR
AVERAGE CAPITAL EMPLOYED
1. LIKE PAYBACK PERIOD, ARR IS ALSO FAIRLY SIMPLE
TO CALCULATE.
2. IT MAY BE INCORPORATED INTO MANAGERS’
CONTRACTS FOR THE PURPOSES OF PAYING
BONUSES, OR OTHERWISE USED TO PROVIDE
PERFORMANCE TARGETS, SO IT IS FAMILIAR TO
MANAGERS.
3. IT CAN BE EASILY RELATED TO INVESTORS’
REQUIRED RATES OF RETURN, AND IS BASED ON
PROFIT FIGURES WHICH ARE WIDELY REPORTED
AND UNDERSTOOD.
• HOWEVER, ALSO LIKE PAYBACK PERIOD, IT HAS A NUMBER OF LIMITATIONS:
1. IT DOES NOT PROVIDE AN ABSOLUTE MEASURE WHICH MEANS THAT IT IS
NECESSARY TO COMPARE ONE ARR TO ANOTHER IN ORDER TO MAKE A
DECISION (IN ISOLATION, THERE IS NO WAY TO KNOW IF AN ARR OF 20
PER CENT IS ‘GOOD’
OR ‘BAD’)
2. IT IGNORES THE ABSOLUTE SIZE OF THE INVESTMENT OUTLAY AND
SUBSEQUENT PROFIT (AND CASH) FLOWS
3. IT USES PROFITS NOT CASH FLOWS SO INCLUDES IRRELEVANT COSTS
SUCH AS DEPRECIATION
4. IT IS SUBJECTIVE (DEPENDS ON CHOICE OF INVESTMENT CALCULATION
AND ACCOUNTING POLICIES).
5. ARR ALSO DOES NOT TAKE INTO ACCOUNT THE ‘TIME VALUE’ OF MONEY.
Accounting rate of return (ARR) (2 of 2)

• Conclusions on ARR:
• It does not relate directly to shareholders’ wealth.
• Its use can lead to illogical conclusions.
• Takes almost no account of the timing of cash flows.
• Ignores some relevant information and may take account of
some irrelevant information.
• Relatively simple to use.
• Much inferior to NPV.

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Table 4.1 Summary of the relative merits of the
four investment appraisal techniques

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Use of appraisal methods in practice

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Thank
You!