Investment Appraisal: Net Present Value

• Discounted cash flow method accounts for the diminishing value of future returns
• Discount factor is used to value future returns in terms of their present worth
• Higher discount factor makes future returns less valuable
• Net present value is calculated by subtracting initial investment from total discounted cash flows
• Discounted cash flow considers both profitability and timing of cash flows

This module explains how to use discounted cash flow as a method of investment appraisal. Discounted cash flow takes into account the diminishing value of potential returns to a business as time goes on. It uses a discount factor to value future returns in terms of their present worth. The higher the discount factor, the less valuable future returns are considered. By multiplying each yearly return by the discount factor, the discounted cash flow for each year is found. The net present value of the investment project is then calculated by adding up all the discounted cash flows and subtracting the initial investment cost. A positive net present value suggests a good investment, while a negative value suggests holding onto the cash is better. Comparing the three projects, project three has the highest net present value and is considered the best investment. Discounted cash flow is a comprehensive method that considers both profitability and timing of cash flows. It is more flexible than other methods as businesses can choose the most appropriate discount factor based on their risk aversion and economic conditions. However, the choice of discount factor can be subjective, and interpreting net present values may be more complex compared to other methods like payback period and average rate of return.