AFMP4
Syllabus B. Advanced Investment Appraisal B1. Discounted cash flow techniques

B1av/vi. Adjusted Payback 10 / 14

Syllabus B1av/vi)

Evaluate the potential value added to an organisation arising from a specified capital investment project or portfolio using the net present value (NPV) model.

Project modelling should include explicit treatment and discussion of:

v) Risk adjusted discount rates
vi) Project duration as a measure of risk.

This incorporates risk into the payback method we looked at earlier in the course

2 Methods

  • Add payback to NPV - Only projects with +ve NPV and payback within specified time chosen

  • Discount cashflows used in payback with a risk adjusted discount rate

Illustration of method 2

Year Cashflow
0 (1,700)
1 500
2 500
3 600
4 900
5 500


Calculate discounted payback at a rate of 12%

Solution

Year Cashflow 12% Cashflow Cumulative
0 (1,700) 1 (1,700) (1,700)
1 500 0.893 446.5 (1,253)
2 500 0.797 398.5 (855)
3 600 0.712 427.2 (427.8)
4 900 0.636 572.4 144.6
5 500 0.567 283.5 428.1


Discounted payback = 3 years 9 months
NPV = 428,100

Risk Adjusted Discount Rates

The discount rate should reflect:

  1. Cost of debt

  2. Cost of equity

The mix of the 2 above adjusted for riskiness

If a project gives additional risks then the discount factor should be altered accordingly. This is called the risk premium