Objectives:
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To understand the time value of money
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To understand and be able to calculate net present values
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To understand the limitations of net present value calculations
Calculating net present values
This is the investment appraisal technique that takes account of the time value
of money. Money is worth more the sooner it is received. Money received in the
future is worth less than money received now. Future flows of money are worth
less to a business than money now because of the following factors:
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the risk of not receiving the money at all
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future uncertainties
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the impact of inflation over time, which reduces the purchasing power of the
money
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if the company had the money now then they could put it in an alternative
investment or receive interest from the bank
Businesses attempt to take account of these factors by discounting future cash
flows. Most companies have centrally set discount rates that must be used for
all projects. This provides a consistent measure when projects are compared.
The company use a cost of capital of 10% when they evaluate projects so any decision that the company make will have to pass this hurdle rate.
Discount factors can be read from a table of Net Present Values - these should be at the back of your textbook. Under exam conditions the factors to be used are provided in a note.
Discount factors are multiplied by the cash flows for the appropriate years to produce a value called the Net Present Value.
Discounted cash flow is a useful technique for businesses to employ. It very simply and effectively takes account of the time value of money. However care needs to be taken to:
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keep in mind all the assumptions and simplifications that have been built into
the calculation
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remember it is more than likely that the project will not produce an outcome that matches perfectly the initial cash flow forecasts - these are best estimates produced in order to help management make decisions; real costs often vary from estimates
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remember that the project will ultimately most likely not produce an outcome
that matches perfectly the initial cash flow forecasts - these are best
estimates produced in order to help management make decisions; real costs often
vary from estimates
Using the Shinkendo Oi case study you can identify quite a few alternative projects. You can also identify a number of other revenue streams that the company might develop. Consider the Net Present Value of the possible outcome of those projects and the projected cash flows that you have developed.
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