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Investment appraisal – Discounted cash flow techniques

Net present value

3.1 The cost of capital

When discounting so far we have referred to the rate of interest. Alternative terms to
be used for this are:

 cost of capital

 discount rate

 required return

You will learn more about the terms ‘cost of capital’ and ‘required return’ in later
chapters.

Whichever term is used, the rate of interest used for discounting reflects
the cost of the finance that will be tied up in the investment.

3.2 Net present value (NPV)

 Discount all the relevant cash flows for a project back to their present values.

 With cash outflows as negative and cash inflows as positive, add up all the
present values to determine the NPV.

The NPV represents the surplus funds (after funding the investment)
earned on the project.

 if the NPV is positive – the project is financially viable (inflows <
outflows)

 if the NPV is zero – the project breaks even (inflows = outflows)

 if the NPV is negative – the project is not financially viable (inflows
< outflows)

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