6-Investment Appraisal

Excellent — this is a big chunk on Investment Decisions, Time Value of Money, and Discounted Cash Flow (DCF). Let me carefully expand it step by step so you can understand concepts, calculations, applications, and pitfalls, then I’ll quiz you at the end.

📌 Investment Decisions and DCF

1. Introduction

  • Successful companies are always exploring new proposals (projects, products, expansions).

  • Problem: Not every proposal is equally good — management must compare and choose.

  • Factors for evaluation:

    1. Alignment with long-term strategy.
    2. Risk attached.
    3. Resources available (money, people, technology).
    4. Return on Investment (ROI).

👉 In practice, ROI is often calculated using Discounted Cash Flow (DCF).

2. Time Value of Money (TVM)

  • Principle: Money today is worth more than money tomorrow.

  • Example: Would you rather have Rs. 100 today or Rs. 103 in 1 year?

    • Depends on interest rate (discount rate).

  • Formula:

    $$ PV = \frac{FV}{(1+r)^t} $$

    where:

    • PV = Present Value
    • FV = Future Value
    • r = interest/discount rate
    • t = number of years

Example:

  • Rs. 1000 receivable in 4 years.
  • Discount rate = 8%.
  • PV = 1000 × (1 ÷ (1.08)^4) = 1000 × 0.735 ≈ Rs. 735.

👉 This shows why future cash flows are “discounted” to today’s value.

3. Car Example (Buy vs Lease)

  • Car Price = £8,995 (one-time payment).
  • Lease option = £500 down + £400/month for 24 months.
  • Discount rate = 3% annual → 0.2466% monthly.

Steps:

  1. Find present value (PV) of each of the 24 monthly £400 payments.
  2. Add them up = £9,310.30.
  3. Add £500 down payment = £9,810.30.

👉 Since £9,810.30 > £8,995 → Better to buy outright.

4. Applying DCF to Projects

DCF is applied to investment projects like:

  • Buying vans, equipment, software, or starting new services.

Steps:

  1. Estimate cash inflows (revenue/savings).
  2. Estimate cash outflows (costs).
  3. Discount them back to present value.
  4. Sum them → Net Present Value (NPV).

Formula:

$$ NPV = \sum \frac{CF_t}{(1+r)^t} - C_0 $$

where:

  • CFₜ = cash flow in year t
  • r = discount rate
  • C₀ = initial investment

5. Investment Evaluation Criteria

  • NPV (Net Present Value)

    • If NPV > 0 → project worthwhile.
    • Higher NPV = better project.

  • Payback Period

    • Time taken to recover investment.
    • Shorter = less risky.

  • IRR (Internal Rate of Return)

    • Discount rate at which NPV = 0.
    • If IRR > cost of capital → accept project.

👉 In practice: Companies may use all three to cross-check decisions.

6. Pitfalls of DCF

  • Looks too precise, but depends on assumptions (interest rate, sales, costs).

  • Sensitive to uncertainty:

    • Software projects often take longer.
    • Sales may be less than expected.
    • Competitors may reduce market share.

Example – Software Project Sensitivity:

  • If Year 3 sales fall from 40 copies → 20 copies → project becomes unprofitable.
  • If price per copy increases from 5000 → 6000 → NPV rises sharply and payback period shortens.

👉 This shows software projects are high risk and sensitive to assumptions.

🎯 Exam-Style Questions for You

Easy Recall

  1. What does DCF stand for and why is it used?
  2. What is the formula for Present Value (PV)?
  3. Define Payback Period and IRR.

Medium Understanding

  1. Why is money today worth more than money tomorrow?
  2. In the car example, why was buying better than leasing?
  3. Why might NPV be a more reliable measure than Payback Period?

Critical Thinking

  1. Suppose you are evaluating a software project where costs are fixed, but revenue predictions are uncertain. How would you test whether the project is high risk or safe?
  2. If two projects have the same NPV but one has a shorter payback period, which would you choose and why?
  3. Why are software projects particularly prone to the pitfalls of DCF analysis?