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

B1a. NPV 1 / 14

Syllabus B1a)

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:

i) Inflation and specific price variation
ii) Taxation including tax allowable depreciation and tax exhaustion

Net Present Value method

This method is examined regularly

What it does is looks at all the projected future CASH inflows and outflows.

Obviously we hope the inflows are more than the outflows. If they are this is called a positive NPV

However, it also introduces the concept of the “time value” of money.

The idea that money coming in today is worth more than the same amount of money coming in in 5 years time. To do this we “discount down” all future cash flows.

This “discounting” takes into account not only the time value of money but also the required return of our share and debt holders.

This means that if we have a positive NPV (even after discounting the future cash flows) then the return beats not only the time value of money but it also beats what the shareholders and debt holders require.

So they will be happy and the company value (and hence share price) will rise by the +NPV amount (divided by the number of shares)

So, let’s look at how we calculate NPVs in an exam..

NPV Proforma

  0 1 2 3 4
Sales   x x x x
Costs   (x) (x) (x) (x)
Profit   x x x x
Tax   (x) (x) (x) (x)
Capital Expense (x)        
Scrap         x
WDA   x x x x
Working capital (x) (x) (x) x x
Total Cashflows (x) x x x x
Discount Factors 1 0.9 0.8 0.7 0.6
Total Cashflows (x) x x x x

The Tax Effect

Tax on operating profits

  • Simply calculate the net profit figure (sales less costs in table) and multiply by the tax rate. 

    This is normally 30%.

    Remember it is normally payable one year later. For example tax on year 1 profits is paid in year 2 (and so goes in the NPV in yr 2)


  • These REDUCE your tax bill!

    They are the tax relief on your capital purchases.

    These are normally 25% writing down allowances on plant & machinery

Calculation technique for WDA

Calculate the amount of capital allowance claimed in each year

Make a balancing adjustment in the year the asset is sold
by calculating the total tax relief that should have been given ((Cost - RV) x 30%) less tax benefits already allowed in step 1

  • Illustration

    Year 0 Buy plant 100
    Year 4 Sell plant 20
    25% Reducing balance; Tax 30%;

  • Answer

    Year 1 WDA 100 x 25% = 25 Tax benefit 7.5
    Year 2 WDA 75 x 25% = 18.75 Tax benefit 5.625
    Year 3 WDA 56.25 x 25% = 14 Tax benefit 4.2

  • Year 4 Total tax relief should be (100-20) x 30% = 24. Less benefits relieved so far (7.5 + 5.625 + 4.2) = 6.675

    Balancing Allowance = Tax benefit 6.675

Working Capital

Think of this as like float in a restaurant. Each night in the restaurant represents a year.

So, lets say a float of 100 is needed at the start of the night (T0). 

Then the following night an extra 20 is required, the following night 30 more & the final night 10 less

At the end of the project it all comes back to the owner

  T0 T1 T2 T3 T4
Working capital -100 -20 -30 10 140

So the technique is for WC is….:

Always start at T0

Just account for increase or decrease

Final year it all comes back as income

The working capital line should always total zero