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Page 172

TABLE 10.9 Payback

The problem with the payback principle is that it is short term. It fails to

consider cash flows beyond the payback period (for example, project A could

make $2m in year 6 and its payback would still be four years).

It should also be noted that payback makes no allowance for interest (for

which a discounted payback is used, see below) and therefore does not measure

the return made by a project.

Net present value

This measure shows the surplus cash made by an investment after funding costs

have been deducted. It uses the principle of discounting cash flows. For

example, if someone is offered $100 now or $100 in one year’s time, they will

choose to receive $100 today, because if interest rates are 10% and the $100 is

invested, in one year it will have grown to $110. This is the concept of the time

value of money. The future value of $100 at a 10% interest rate is shown in

Table 10.10.

TABLE 10.10 Future value of $100 at 10% interest rate

Page 173

This uses the principle of compound interest. However, if someone is offered

$110 in one year’s time or $121 in two years’ time, the choice becomes more

difficult. From Table 10.10 it is clear that they are both worth $121 at the end of

two years. The ability to compare depends on choosing the same point in time

whether it is now, in two years’ time or in ten years’ time. Each cash flow needs

to be either compounded to find a future value or discounted to find a present

value.

The two options would both be the equivalent of receiving $100 today. The

principle of working out what a future cash flow is worth now is the basis for all

project appraisal and company valuations. The year 0 value of a future cash flow

is known as its present value (PV). Adding together the PV of each cash flow in

a project provides the net present value (NPV).

To find the NPV of the cash flows in project A the procedure is as follows:

using a discount rate of 10%, each future cash flow can be multiplied by 100 and

divided by the compound interest value from Table 10.10 (see Figure 10.5).

The NPV of project A is therefore $651, which is substantially less than the

apparent surplus of $5,000 found by simply adding the series of cash flows. The

reduction is caused by having to fund the investment in the early years of the

project.

FIG 10.5 NPV calculation

A better way to find the PV of a cash flow is to use the formula:

To apply the formula the interest rate is expressed as a fraction so 10% would

be shown as 0.1. The ^ symbol means “to the power”, for example if the number

Page 344

perception 130–134, 141

proposition 134–137

realisation 138

value-added tax 193–194

value pricing 141, 142

variable costs 107–109, 339

variance analysis 221–228, 340

Vause, Bob 233

vendor financed programmes 301

vendor-managed inventory (VMI) 291–292, 340

vertical analysis 216–217, 340

vertical integration 145

volume discounts 158–160, 303

vouchers, incentive 69–70

W

WACC (weighted average cost of capital) 9–12, 99–101, 340

factors affecting 98

inflation impact 191–192

taxation impact 194

use for calculating NPV 186–187

warranties 58–59

warrants 80

wastage 120

weighted average cost of capital (WACC) 9–12, 99–101, 340

factors affecting 98

inflation impact 191–192

taxation impact 194

use for calculating NPV 186–187

wholesale businesses 111

work in progress 340

working capital 38, 179–181, 340

cycle 251

Page 345

funding 82–83

inventory management 284–294, 304

optimisation 281–284

payables 302–304

receivables management 294–301

working capital turnover 250–251, 283

Y

yield variances 225–226

Z

Zehle, S. 204

zero-based budgeting 212, 340

zero-coupon 101

TABLE 10.9 Payback

The problem with the payback principle is that it is short term. It fails to

consider cash flows beyond the payback period (for example, project A could

make $2m in year 6 and its payback would still be four years).

It should also be noted that payback makes no allowance for interest (for

which a discounted payback is used, see below) and therefore does not measure

the return made by a project.

Net present value

This measure shows the surplus cash made by an investment after funding costs

have been deducted. It uses the principle of discounting cash flows. For

example, if someone is offered $100 now or $100 in one year’s time, they will

choose to receive $100 today, because if interest rates are 10% and the $100 is

invested, in one year it will have grown to $110. This is the concept of the time

value of money. The future value of $100 at a 10% interest rate is shown in

Table 10.10.

TABLE 10.10 Future value of $100 at 10% interest rate

Page 173

This uses the principle of compound interest. However, if someone is offered

$110 in one year’s time or $121 in two years’ time, the choice becomes more

difficult. From Table 10.10 it is clear that they are both worth $121 at the end of

two years. The ability to compare depends on choosing the same point in time

whether it is now, in two years’ time or in ten years’ time. Each cash flow needs

to be either compounded to find a future value or discounted to find a present

value.

The two options would both be the equivalent of receiving $100 today. The

principle of working out what a future cash flow is worth now is the basis for all

project appraisal and company valuations. The year 0 value of a future cash flow

is known as its present value (PV). Adding together the PV of each cash flow in

a project provides the net present value (NPV).

To find the NPV of the cash flows in project A the procedure is as follows:

using a discount rate of 10%, each future cash flow can be multiplied by 100 and

divided by the compound interest value from Table 10.10 (see Figure 10.5).

The NPV of project A is therefore $651, which is substantially less than the

apparent surplus of $5,000 found by simply adding the series of cash flows. The

reduction is caused by having to fund the investment in the early years of the

project.

FIG 10.5 NPV calculation

A better way to find the PV of a cash flow is to use the formula:

To apply the formula the interest rate is expressed as a fraction so 10% would

be shown as 0.1. The ^ symbol means “to the power”, for example if the number

Page 344

perception 130–134, 141

proposition 134–137

realisation 138

value-added tax 193–194

value pricing 141, 142

variable costs 107–109, 339

variance analysis 221–228, 340

Vause, Bob 233

vendor financed programmes 301

vendor-managed inventory (VMI) 291–292, 340

vertical analysis 216–217, 340

vertical integration 145

volume discounts 158–160, 303

vouchers, incentive 69–70

W

WACC (weighted average cost of capital) 9–12, 99–101, 340

factors affecting 98

inflation impact 191–192

taxation impact 194

use for calculating NPV 186–187

warranties 58–59

warrants 80

wastage 120

weighted average cost of capital (WACC) 9–12, 99–101, 340

factors affecting 98

inflation impact 191–192

taxation impact 194

use for calculating NPV 186–187

wholesale businesses 111

work in progress 340

working capital 38, 179–181, 340

cycle 251

Page 345

funding 82–83

inventory management 284–294, 304

optimisation 281–284

payables 302–304

receivables management 294–301

working capital turnover 250–251, 283

Y

yield variances 225–226

Z

Zehle, S. 204

zero-based budgeting 212, 340

zero-coupon 101