PMB Seminar session LSBM , Week 2

Appraisal Methods Payback method - length of time it takes to repay the cost of initial investment

Payback Period Example 1 LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests £30,000 to replace its computers and this investment returns £9,000 annually for the five years. From the information above evaluate the investment using the payback. Assume that £9,000 accrues evenly throughout the year.

Payback Period Solution for 1 Year Yearly cash flow cumulative net cash flow £ £ 0 (30,000) (30,000) 1 9,000 (21,000 2 9,000 (12,000) 3 9,000 (3,000) 4 9,000 6,000 5 9,000 15,000 Therefore 3years = 27,000 then 3000/9000 x 12 = 4 Payback period = 3 years 4months

Example 2

Example 2 solution Undiscounted pay back For A = 4 years For B = 5 years

Example 2 solution

Example 2 solution For A, payback is outside the project’s life For B payback is 6.25 years .

Appraisal Methods Net Present Value (NPV) - the difference between the present values of cash inflows and outflows of an investment Opportunity cost of undertaking the investment is the alternative of earning interest rate in the financial market.

NPV

Definitions Present value:- the amount of money you must invest or lend at the present time so as to end up with a particular amount of money in the future. Discounting: -finding the present value of a future cash flow

Quick exercise

Example 4 A company can purchase a machine at the price of £2200. The machine has a productive life of three years and the net additions to cash inflows at the end of each of the three years are £770, £968 and £1331. The company can buy the machine without having to borrow and the best alternative is investment elsewhere at an interest rate of 10%. Evaluate the project using the Net present value method.

Example 4: solution

Net Present Value Example 5 A firm invest £180,000 in a project that will give a net cash inflow of 50,000 in real terms in each of the next six years. Its real pre-tax cost of capital is 13%. Required: Calculate NPV

Net Present Value Solution 5 Year Cash Flow PV factor 13% Present value 0 (180,000) 1.00 (180,000) 1 50,000 0.885 44,250 2 50,000 0.783 39,150 3 50,000 0.693 34,650 4 50,000 0.613 30,650 5 50,000 0.543 27,150 6 50,000 0.480 24,000 NPV 19,850 Positive NPV indicates viability of the project. Negative NPV indicates non-viability of the project.

End of Seminar Any question please?