Cash Flow and Time Value of Money

Making capital investment decisions

 The scale of investment by UK businesses

Business Expenditure on additional fixed assets as a

percentage of:

Annual sales Start of year non-current assets

J D Wetherspoon plc 9.5 9.6
A
Astra-Zeneca
Z plc
l 8
8.7 1 3
17.3
Bristol Water plc 23.2 15.2
Royal
y Dutch/Shell Group
p 6.1 11.7
Chloride plc 5.5 15.2
Yates Group plc 9.6 6.2
U i d Utilities
United U ili i 49 4
49.4 14 1
14.1
Tesco plc 7.3 15.9
J. Sainsbury
ypplc 5.7 12.5

Source: Annual reports of the businesses concerned for the accounting years ending in 2003 or 2004
Time Value of Money

A pound today is worth:‐

1. More than tomorrow?
2. Less than tomorrow?
Time Value of Money

If you lend me £ 100 today

how much would you want returned
to you in 12 months time?
Time Value of Money

A pound today is worth:‐

1. More than tomorrow?

Opportunity Cost
Inflation / Depreciation / Risk
Present value of £1 receivable at various times in the future, assuming an
annual financing cost of 20%

100
£1
ce
Penc

90

80
70

60
50

40
30

20

10

0 1 2 3 4 5 6 7 8 9 10
Years into the future
Methods of investment appraisal

Four methods of
evaluation

Accounting rate of
return (ARR)

Payback period (PP)

Net present value

(NPV)

Internal rate of return

(IRR)
 Accounting rate of return (ARR)

ARR = Average annuall profit

A fit x 100%
Average investment to earn that profit
 Payback period (PP)

The payback period is the

length
g of time it takes for
Payback period the initial investment to be
(PP) repaid out of the net cash
inflows from the project.
 The cumulative cash flows of each project in Activity 10.6

Initial outlay
Payback
period

Yr Yr Yr Yr Yr
Project 1
1 2 3 4 5

Yr Y
Y Yr Y Y
Project 2 1
12 3 4 5

Yr Yr Yr Yr Yr
Project 3
1 2 3 4 5

0 100 200 300 400 500 600 700 800 900

Cash flows (£000)
The factors influencing the returns required by investors from a
project

Interest Required
Inflation
foregone return

Risk
premium
Why NPV is superior to ARR and PP

NPV fully addresses each of the following:

The timing of the cash flows

The whole of the relevant cash flows

The objectives of the business

 Internal rate of return (IRR)

The internal rate of return is the

discount rate,
rate which
which, when
Internal rate of applied to the future cash flows
return (IRR) of a project, will produce an
NPV of precisely zero.
The relationship between the NPV and IRR methods

70
NPV
(£000)
60

50

40

30

20
IRR
10

0 10 20 30 40

Rate of return (%)

Dealing with questions relating to investment appraisal

Some practical points

Cash flows not

Past costs
profit flows

Common Year-end
future costs assumption
p

Opportunity Interest
costs payments

Taxation Other
factors
 Investment appraisal in practice

Many surveys have tended to show:

Businesses using more than one method to assess

each investment decision

An increased use of the discounting methods

((NPV and IRR)) over time

Continued popularity of ARR and payback period

A tendency for larger businesses to use the discounting

methods and to use more than one method