Chapter 7

Discounting and investment appraisal

Outcome

By the end of this session you should be able to:

 calculate future values of an investment using both simple and compound

interest

 calculate the present value of a future cash sum, an annuity and a perpetuity

 calculate the net present value (NPV) and internal rate of return (IRR) of a
project and explain whether and why it should be accepted

and answer questions relating to these areas.

The underpinning detail for this chapter in your Integrated Workbook can
be found in Chapter 7 of your Study Text

121
Chapter 7

Overview

Time value of Simple Compound

money interest interest

INVESTMENT
APPRAISAL

Discounted cash
flows

NPV IRR

Annuities and
perpetuities

122
 Discounting and investment appraisal

Time value of money

1.1 Introduction

Money received today is worth more than the same amount received in
the future, i.e. it has a time value.

Discounted cash flow techniques take account of this time value of

money when appraising investments.

1.2 Why money has a time value

 Cost of finance

 Investment opportunities

 Inflation

 Risk

1.3 Discount rates

 Time value of money expressed as an interest rate, also known as a “discount

rate”, a “cost of capital” and/or a “required return”

123
Chapter 7

Calculations – simple interest

2.1 Introduction

With simple interest the interest on a loan or deposit is calculated by

reference to the principal only – i.e. the original sum invested.

2.2 Calculation

V = P (1 + r × n)
Where V = future value

P = initial investment (principal)

r= interest rate (expressed as a decimal)

n = number of time periods

124
 Discounting and investment appraisal

Question 1
By calculating simple interest, you are demonstrating the maths skill of
working out percentages of amounts.

Simple interest

An amount of $600 is invested for 2 years earning simple interest at a rate of

5% per year. What is the final sum on the account at the end of two years?

$600 × 5% × 2 = $60 interest earned

Total balance = $600 + $60 = $660

Question 2
Simple interest formula

An amount of $1,500 is invested for 3 years into an account earning simple

interest at a rate of 0.2% per month. What is the final sum on the account at the
end of three years?

V = P(1 + r × n)

P = $1,500, r = 0.002, n = 36

V = $1,500 (1 + 0.002 × 36) = $1,608

125
Chapter 7

Calculations – compound interest

3.1 Introduction

With compound interest the interest on a loan or deposit is calculated

by reference to the principal plus any accrued interest.

3.2 Calculation

V = P (1 + r)n

3.3 Equivalent rates of interest

 Use idea of compounding to get equivalent rates

 E.g. 4% for 6 months equivalent to (1.042 – 1) = 0.0816 or 8.16% per annum

A three step approach can be used to calculate equivalent rates:

 For the rate given, add 1 to its decimal value – from above this gives 1.04

 Take this value to the power of the number periods of the rate you’re using are
in the period of the rate you’re looking for – from above, this gives 1.042

 Take 1 off the answer – from above this gives 1.042 – 1 = 0.0816

126
 Discounting and investment appraisal

Question 3
By calculating compound interest, you are demonstrating the maths skill
of working out percentages of amounts.

Compound interest

An amount of $600 is invested for 2 years earning compound interest at a rate

of 5% per year. What is the final sum on the account at the end of two years?

Year 1: $600 × 5% = $30 interest earned and balance on account is $630

Year 2: $630 × 5% = $31.50 interest earned and balance on account is $661.50

Question 4
Compound interest formula

An amount of $1,500 is invested for 3 years into an account earning compound

interest at a rate of 0.2% per month. What is the final sum on the account at the
end of three years?

V = P(1 + r)n

P = $1,500, r = 0.002, n = 36

V = $1,500 (1 + 0.002)36 = $1,611.87

127
Chapter 7

Question 5
By calculating the equivalent rate of interest, you are demonstrating the
maths skill of identifying and knowing the equivalence between decimals
and percentages.

Equivalent rates of interest

A deposit interest rate is stated as 12% per annum with interest calculated and
added to the deposit every month.

Calculate the effective annual rate of interest.

1% will be calculated every month.

Consider the effect on a deposit of $1, using V = P(1 + r)n

$1 × 1.0112 = $1.1268

In other words 12.68% of interest has been added over a year – this is the
effective annual interest rate.

Illustrations and further practice

Now read illustrations 1 to 4 and try TYUs 1 to 8 from Chapter 7.

128
 Discounting and investment appraisal

Discounting

4.1 Introduction

Discounting performs the opposite function to compounding: it

considers a sum receivable in the future and establishes its equivalent
value today. This value, in today’s terms, is known as the Present Value
(PV).

4.2 Calculation for discounting a single value

PV = Future Value × Discount Factor (DF)

1
Where DF = , or DF = (1 + r) –n
ሺ1 + rሻn

(1 + r) –n can be looked up in discounting tables

129
Chapter 7

Question 6
By calculating present values using the formula, you are demonstrating
the maths skill of following the order of precedence of operators,
including indices.

Discounting

Calculate the present values of the following amounts:

1 $5,000 payable in 5 years’ time with a rate of 6%

2 $99,000 payable in 9 years’ time with a rate of 3%

3 $55,000 payable in 12 years’ time with an interest rate of 4.5%

Using P = F(1 + r)–n

1 P = $5,000 × 1.06–5 = $3,736

2 P = $99,000 × 1.03–9 = $75,875

3 P = $55,000 × 1.045–12 = $32,432

130
 Discounting and investment appraisal

Question 7
Discounting using tables

Calculate the present values of the following amounts:

1 $5,000 payable in 5 years’ time with a rate of 6%

2 $99,000 payable in 9 years’ time with a rate of 3%

3 $55,000 payable in 12 years’ time with an interest rate of 4.5%

Using tables

1 P = $5,000 × 0.747 = $3,735

2 P = $99,000 × 0.766 = $75,834

3 Tables only contain whole numbers for discount factors, so can’t be done

Illustrations and further practice

Now read illustrations 5 and 6 and try TYU 9 from Chapter 7.

131
Chapter 7

Net Present Value

5.1 Introduction

The Net Present Value (NPV) is the net benefit or loss of benefit, in
present value terms, from an investment opportunity. It represents the
surplus funds (after funding the investment) earned on the project, and
calculates the impact on shareholders’ wealth.

5.2 Decision Criteria

 A project with a positive NPV is viable.

 A project with a negative NPV is not viable.

 Faced with mutually-exclusive projects, choose the project

with the highest NPV.

5.3 Calculation
Narrative T=0 T=1 T=2 T=3 T=4 T=5
Invest (X)
Sales X X X X X
Costs (X) (X) (X) (X) (X)
Net CF (X) X X X X X
DF @ r% 1 (1+r)–1 (1+r)–2 (1+r)–3 (1+r)–4 (1+r)–5
Present Value PV (X) X X X X X

132
 Discounting and investment appraisal

Question 8
By determining net present values, you are developing the technical
knowledge related to investment appraisal.

Net present value

Calculate the net present value of the following cash flows, discounted at a rate
of 5%:
Timing Cash flow
0 (70,000)
1 30,000
2 20,000
3 15,000
4 15,000

Timing Cash flow Discount Present

factor value
0 (70,000) 1 (70,000)
1 30,000 0.952 28,560
2 20,000 0.907 18,140
3 15,000 0.864 12,960
4 15,000 0.823 12,345
NPV = 2,005

133
Chapter 7

Question 9
Net present value

Calculate the net present value of the following cash flows, discounted at a rate
of 10%:
Timing Cash flow
0 (9,000)
1 4,000
2 2,500
3 2,000
4 2,000

Timing Cash flow Discount Present

factor value
0 (9,000) 1 (9,000)
1 4,000 0.909 3,636
2 2,500 0.826 2,065
3 2,000 0.751 1,502
4 2,000 0.683 1,366
NPV = (431)

Illustrations and further practice

Now read illustration 7 ‘Net present value’ and try TYUs 10 to 12
from Chapter 7.

134
 Discounting and investment appraisal

Discounting annuities and perpetuities

6.1 Annuities

An annuity is a constant annual cash flow for a number of years, When

a project has equal annual cash flows, the annuity factor may be used
to calculate the NPV. The annuity factor (AF) is the name given to the
sum of the individual DFs.

The present value (PV) of an annuity can therefore quickly be found:

PV = Annual cash flow × AF

1 – (1 + r)–n
With AF = ––––––––
r

6.2 perpetuities

A perpetuity is an annual cash flow that occurs forever.

The present value (PV) of a perpetuity can therefore quickly be

found:

PV = Annual cash flow/r

1
or PV = cash flow × –
r

135
Chapter 7

Question 10
By calculating present values of annuities using the formula, you are
demonstrating the maths skill of following the order of precedence of
operators, including indices.

Discounting annuities

Calculate the present value of an annuity that pays out $6,000 per year starting
in 1 years' time for 15 years if the discount rate is 7%.

Annuity factor for 15 years at 7% = (1 – (1 + 0.07)–15)/0.07 = 9.107914

Present value = cash flow × annuity factor

Present value = $6,000 × 9.107914 = $54,647

Question 11
Annuities using tables

Calculate the present value of an annuity that pays out $6,000 per year starting
in 1 years' time for 15 years if the discount rate is 7%.

Annuity factor for 15 years at 7% from tables is 9.108

Present value = cash flow × annuity factor

Present value = $6,000 × 9.108 = $54,648

136
 Discounting and investment appraisal

Question 12
By calculating the present value of perpetuities, you are demonstrating
the maths skill of dividing decimals up to three decimal places.

Discounting perpetuities

Calculate the present value of a perpetuity that pays out $6,000 per year
starting in 1 years' time if the discount rate is 7%.

Present value = cash flow × perpetuity factor

Present value = $6,000 × 1/0.07 = $85,714

Illustrations and further practice

Now read illustrations 8 and 9 and try TYUs 13 to 18 from
Chapter 7.

137
Chapter 7

6.3 Annuities and perpetuities that don’t start in 1 years’ time

The use of an annuity factor or perpetuity factor comes with the assumption that the
series of cash flows starts at time period 1 (t1 = 1 year from today).

 If instead the cash flow starts at t0 (today) this is known as an advanced annuity
or perpetuity.

Ignore the t0 cash flow completely and add one to the discount factor (for the
remaining cash flows) before multiplying by the cash flow value.

 If instead the cash flow starts at a time period later than t1 this is known as a
delayed annuity or perpetuity.

Apply the appropriate annuity/perpetuity factor to the cash flows as usual. This
will discount the series of cash flows to a single figure as at one time period
before the cash flows started.

Then discount the single cash flow back to t0 using the appropriate discount
factor.

138
 Discounting and investment appraisal

Question 13
Advanced and delayed annuities and perpetuities

Calculate the present values of the following at a discount rate of 10%:

(a) A series of 3 annual payments of $5,000 starting today.

(b) A series of 3 annual payments of $5,000 starting in 4 years’ time.

(c) A series of annual payments of $5,000 starting today and continuing for
the foreseeable future.

(d) A series of annual payments of $5,000 starting in 6 years’ time and

continuing for the foreseeable future.

(a) use annuity factor for 2 years and add 1 to its value

$5,000 × (1 + 1.736) = $13,680

(b) use 3-year annuity factor to discount to a single sum as at t3, then use 3-
year discount factor to discount the single sum back to t0.

$5,000 × 2.487 × 0.751 = $$9,339

(c) use perpetuity factor and add 1 to its value

$5,000 × (1 + 1/0.1) = $55.000

(d) Use perpetuity factor to discount to a single sum as at t5, then use the 5-
year discount factor to discount the single sum back to t0

$5,000 × 1/0.1 × 0.621 = $31,050

Illustrations and further practice

Now try TYU 19 from Chapter 7.

139
Chapter 7

The Internal Rate of Return

7.1 Introduction

What if we discount the cash flows of a project at different interest rates? We will get
different NPVs. In general, at higher interest rates, NPVs will fall. This is because at
higher rates the time value of money is increased and the difference between the
future and present values is therefore greater.

The Internal Rate of Return (IRR) is the discount rate at which the
project has an NPV of zero.

7.2 Decision Criteria

 If the IRR > cost of capital, the project should be accepted.

 If the IRR < cost of capital, the project should be rejected.

7.3 Calculation

Calculate two NPVs for the project at two different costs of capital.
Then use linear interpolation:
NPV1
IRR = R1 + (R2 – R1) ×
NPV1 – NPV2

Where R1 = Lower rate of interest

R2 = Higher rate of interest

NPV1 = NPV at the lower rate of interest

NPV2 = NPV at higher rate of interest

140
 Discounting and investment appraisal

Question 14
By determining the internal rate of return, you are developing the
technical knowledge related to investment appraisal.

IRR

Calculate the internal rate of return (IRR) of the following cash flows. The NPV
at 5% is 2,005. Use 10% as the second discount rate.
Timing Cash flow
0 (70,000)
1 30,000
2 20,000
3 15,000
4 15,000

Timing Cash flow Discount Present

factor value
0 (70,000) 1 (70,000)
1 30,000 0.909 27,270
2 20,000 0.826 16,520
3 15,000 0.751 11,265
4 15,000 0.683 10,245
NPV = (4,700)

IRR = 5 + (2,005/(2,005 + 4,700)) × (10 – 5)

IRR = 5 + 0.299 × 5

IRR = 6.5%

141
Chapter 7

Question 15
Calculate the internal rate of return (IRR) of the following cash flows. The NPV
at 10% is (431). Use 5% as the second discount rate.
Timing Cash flow
0 (9,000)
1 4,000
2 2,500
3 2,000
4 2,000

Timing Cash flow Discount Present

factor value
0 (9,000) 1 (9,000)
1 4,000 0.952 3,808
2 2,500 0.907 2,268
3 2,000 0.864 1,728
4 2,000 0.823 1,646
NPV = 450

IRR = 5 + (450/(450 + 431)) × (10 – 5)

IRR = 5 + 0.5108 × 5

IRR = 7.6%

142
 Discounting and investment appraisal

Illustrations and further practice

Now read illustration 10 and try TYU 20 from Chapter 7.

143
Chapter 7

Terminal values and sinking funds

8.1 Terminal values

The terminal value of a project is found by compounding all of the

individual cash flows to the end of the project and then adding them up.

8.2 Sinking funds

A sinking fund is a special type of investment in which a constant amount

is invested each year, usually with a view to reaching a specified value at
a given point in the future (its terminal value).

144
 Discounting and investment appraisal

Question 16
By calculating the terminal value, you are demonstrating the maths skill of
solving mathematical problems.

Terminal values

Calculate the terminal value in 5 years’ time of a series of 6 receipts of

$5,000 received a year apart starting today if the interest rate is 4%.

TV = $5,000 × 1.045 + $5,000 × 1.044 + $5,000 × 1.043 + $5,000 × 1.042

+ $5,000 × 1.04 + $5,000 = $33,165

Question 17
Sinking funds

Calculate the amount needed to set aside each year in a sinking fund to provide
$11,500 in 4 years’ time if the first amount is set aside today and interest of
7% is earned per annum on the set aside funds. Assume that five amounts are
set aside, with the last amount in 4 years’ time.

TV = $11,500 = ? × 1.074 + ? × 1.073 + ? × 1.072 + ? × 1.07 + ?

$11,500 = ? (1.074 + 1.073 + 1.072 + 1.07 + 1)

$11,500 = ? × 5.7507

? = $11,500/5.7507 = $2,000

Illustrations and further practice

Now read illustrations 11 and 12 and try TYU 21 from Chapter 7.

145
Chapter 7

You should now be able to answers all the questions from chapter 7 of
the Study Text and questions 142 – 161 from the Exam Practice Kit.

For further reading, visit Chapter 7 from the Study Text

146
 Discounting and investment appraisal

Answers

Question 1
$600 × 5% × 2 = $60 interest earned

Total balance = $600 + $60 = $660

Question 2
V = P(1 + r × n)

P = $1,500, r = 0.002, n = 36

V = $1,500 (1 + 0.002 × 36) = $1,608

Question 3
Year 1: $600 × 5% = $30 interest earned and balance on account is $630

Year 2: $630 × 5% = $31.50 interest earned and balance on account is $661.50

147
Chapter 7

Question 4
V = P(1 + r)n

P = $1,500, r = 0.002, n = 36

V = $1,500 (1 + 0.002)36 = $1,611.87

Question 5
1% will be calculated every month.

Consider the effect on a deposit of $1, using V = P(1 + r)n

$1 × 1.0112 = $1.1268

In other words 12.68% of interest has been added over a year – this is the
effective annual interest rate.

Question 6
Using P = F(1 + r)–n

1 P = $5,000 × 1.06–5 = $3,736

2 P = $99,000 × 1.03–9 = $75,875

3 P = $55,000 × 1.045–12 = $32,432

148
 Discounting and investment appraisal

Question 7
Using tables

1 P = $5,000 × 0.747 = $3,735

2 P = $99,000 × 0.766 = $75,834

3 Tables only contain whole numbers for discount factors, so can’t be done

Question 8
Timing Cash flow Discount Present
factor value
0 (70,000) 1 (70,000)
1 30,000 0.952 28,560
2 20,000 0.907 18,140
3 15,000 0.864 12,960
4 15,000 0.823 12,345
NPV = 2,005

149
Chapter 7

Question 9
Timing Cash flow Discount Present
factor value
0 (9,000) 1 (9,000)
1 4,000 0.909 3,636
2 2,500 0.826 2,065
3 2,000 0.751 1,502
4 2,000 0.683 1,366
NPV = (431)

Question 10
Annuity factor for 15 years at 7% = (1 – (1 + 0.07)–15)/0.07 = 9.107914

Present value = cash flow × annuity factor

Present value = $6,000 × 9.107914 = $54,647

Question 11
Annuity factor for 15 years at 7% from tables is 9.108

Present value = cash flow × annuity factor

Present value = $6,000 × 9.108 = $54,648

150
 Discounting and investment appraisal

Question 12
Present value = cash flow × perpetuity factor

Present value = $6,000 × 1/0.07 = $85,714

Question 13
(a) use annuity factor for 2 years and add 1 to its value

$5,000 × (1 + 1.736) = $13,680

(b) use 3-year annuity factor to discount to a single sum as at t3, then use 3-
year discount factor to discount the single sum back to t0.

$5,000 × 2.487 × 0.751 = $$9,339

(c) use perpetuity factor and add 1 to its value

$5,000 × (1 + 1/0.1) = $55.000

(d) Use perpetuity factor to discount to a single sum as at t5, then use the 5-
year discount factor to discount the single sum back to t0

$5,000 × 1/0.1 × 0.621 = $31,050

151
Chapter 7

Question 14
Timing Cash flow Discount Present
factor value
0 (70,000) 1 (70,000)
1 30,000 0.909 27,270
2 20,000 0.826 16,520
3 15,000 0.751 11,265
4 15,000 0.683 10,245
NPV = (4,700)

IRR = 5 + (2,005/(2,005 + 4,700)) × (10 – 5)

IRR = 5 + 0.299 × 5

IRR = 6.5%

Question 15
Timing Cash flow Discount Present
factor value
0 (9,000) 1 (9,000)
1 4,000 0.952 3,808
2 2,500 0.907 2,268
3 2,000 0.864 1,728
4 2,000 0.823 1,646
NPV = 450

IRR = 5 + (450/(450 + 431)) × (10 – 5)

IRR = 5 + 0.5108 × 5

IRR = 7.6%

152
 Discounting and investment appraisal

Question 16
TV = $5,000 × 1.045 + $5,000 × 1.044 + $5,000 × 1.043 + $5,000 × 1.042

+ $5,000 × 1.04 + $5,000 = $33,165

Question 17
TV = $11,500 = ? × 1.074 + ? × 1.073 + ? × 1.072 + ? × 1.07 + ?

$11,500 = ? (1.074 + 1.073 + 1.072 + 1.07 + 1)

$11,500 = ? × 5.7507

? = $11,500/5.7507 = $2,000

153
Chapter 7

154