Level 6 Financial Management

Week 1 – Investment Appraisal Revision

NPV’s – variations

Timing of cash flows

E.g. Asset purchased: 31.12.X1 If in doubt, draw a time chart:
Income arising: 1.1.X2 t0 t1 t2 t3 t4 t5
31.12.X2 I_________I_________I_________I_________I_________I
1.1.X4 31.12.X1 31.12.X2 1.1.X4 1.1.X5 31.12.X5
1.1.X5 1.1.X2 1.1.X6
31.12.X5
1.1.X6

Q1. SINGLE SUM DISCOUNT FACTORS

E.g. initial investment £15,000; income £7,000 p.a. for four years; discount rate 12%.

Q2. ANNUITY DISCOUNT FACTORS

Same example as above; use annuity factors.

Q3. PERPETUITY DISCOUNT FACTORS

E.g. initial investment £150,000; income £75,000 p.a in perpetuity; discount rate 12.5%

Q4. DELAYED ANNUITIES/ ANNUITIES IN ADVANCE

(I) E.g. initial investment £25,000; income £9,000 p.a. for four years starting
three years from now; discount rate 11%.

(II) E.g. initial investment £50,000; income £17,000 p.a. for four years starting
immediately; discount rate 10%.

Q5. CHANGES IN THE DISCOUNT RATE

E.g. discount rate = 10% p.a. for first two years; 11% p.a. for the third year; 15%
p.a. thereafter. Calculate discount factors for cash flows at t1, t2, t3, t4, t5 and t9.
Level 6 Financial Management
Week 1 – Investment Appraisal Revision

A1. SINGLE SUM DISCOUNT FACTORS DF = 1/(1+r)n, or use PV tables

TIME CASH FLOW (£) DF (12%) PRESENT VALUE (£)

0 (15,000) 1 (15,000)
1 7,000 1/1.12 = 0.893 6,251
2 7,000 1/1.122 = 0.797 5,579
3
3 7,000 1/1.12 = 0.712 4,984
4 7,000 1/1.124 = 0.636 4,452
NPV: +6,266

A2. ANNUITY DISCOUNT FACTORS AF(1-4) = 1-(1.12)-4 = 3.037, or use AF tables

0.12

TIME CASH FLOW (£) DF (12%) PRESENT VALUE (£)

0 (15,000) 1 (15,000)
1-4 7,000 3.037 21,259
NPV: +6,259

A3. PERPETUITY DISCOUNT FACTORS PDF = 1/r

TIME CASH FLOW (£) DF (12.5%) PRESENT VALUE (£)

0 (150,000) 1 (150,000)
1-∞ 75,000 1/0.125 = 8 600,000
NPV: +450,000

A4. (I) DELAYED ANNUITIES – starts later than time 1 (AF3-6 = AF1-6 – AF1-2)

TIME CASH FLOW (£) DF (11%) PRESENT VALUE (£)

0 (25,000) 1 (25,000)
3-6 9,000 2.518 22,662
NPV: (2,338)
Level 6 Financial Management
Week 1 – Investment Appraisal Revision

A4. (II) ANNUITIES IN ADVANCE - starts immediately (AF1-3 + 1)

TIME CASH FLOW (£) DF (10%) PRESENT VALUE (£)

0 (50,000) 1 (50,000)
0-3 17,000 1 + 2.487 = 3.487 59,279
NPV: +9,279

A5. CHANGES IN THE DISCOUNT RATE

Compounding = multiplying by factor (1 + r) n to achieve terminal value,
E.g. £100 x 1.12 x 1.11 x 1.152
V’s Discounting = reversing the compound process, ie 1
1.1 x 1.11 x 1.152
2

Best to draw a time chart:

t0 t1 t2 t3 t4 t5 t6 t7 t8 t9
I_________I_________I_________I________I_________I_______I________ I________ I________I
10% 10% 11% 15% 15% 15% 15% 15% 15%

t1 DF = 1/1.1 = 0.909

t2 DF = 1/1.12 = 0.826

t3 DF = 1/1.12 x 1/1.11 = 0.826 x 0.901 = 0.744

t4 DF = 1/1.12 x 1/1.11 x 1/1.15 = 0.826 x 0.901 x 0.87 = 0.647

t5 DF = 1/1.12 x 1/1.11 x 1/1.152 = 0.826 x 0.901 x 0.756 = 0.563

t9 DF = 1/1.12 x 1/1.11 x 1/1.156 = 0.826 x 0.901 x 0.432 = 0.322