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Investment appraisal is crucial factor for many multinational or domestic companies which have enough resources to expand their activities or launch new businesses. But investing in project is always related to big risk because the project can either gain profit or bring serious damage to company as it fails. There are two types of investment appraisals: traditional and discounted cash flow methods. Many companies use traditional investment appraisal methods but more and more companies conduct to new, discounted cash flow methods (http://www.bized.co.uk/timeweb/reference/using_experiments.htm).
Present Value of future cash flows is the value of money that is estimated to be received in future as net cash flows (cash inflows - cash outflows) transformed to present situation considering risks, inflation and other factors which is called discount rate. Present value is calculated with following formula:
Where, PV = Present Value;
r = discount rate based on the opportunity cost of capital;
n = number of years;
(K. Patra, 2006, p.227)
In this particular situation, where discount rate is 10%, Present Value e. g. for second year will be calculated in following way:
Which means that Present Value of each £1 received in two years will be £0.826. To calculate Present value of 10 % discount rate for year one for LSC Corporation, all cash inflows and outflows must be considered to get correct net cash flow. In first year company expects to get £70,000 revenues and £50,000 expenses. Before tax earnings will be £20,000 but tax will reduce the earnings by 36%, which means that earnings after tax will be £12,800. Discount rate is 10% and according to the Present value formula discounted cash flow will be 0.9091. So present value of cash flows in year one will be £12,800*0.9091=£11,636.36
The following table illustrates Present values of cash flows for each year. In eighth year £5000 is added to net cash flow as the salvage value of machinery. Net cash flow for eighth year will be: £70,000+(£50,000)+£5,000=£25,000. Earnings after tax will be £16,000 (£25,000-£25,000*0.36):
R. A. Arnold (2008, p.146) describes the process of product breakdown, natural wear or accidental destruction and the cost to repair or replace the product that is worn out is called capital consumption allowance, or depreciation. "We add capital consumption allowance, or depreciation, in national income because we want a measure of all income earned in the company. National income, by itself, does not include the income payments implicit in the capital consumption allowance" (R. A. Arnold, 2008, p.146).
For tax purposes companies are allowed to deduct capital consumption allowances. In most countries CCA is protected by tax shield (Krishnamutri/vishwanath, 2009, p.16). "Tax shield is a deductible expense. The expense protects (shields) an equivalent dollar (British Pound) amount of revenue from being taxed by reducing taxable income" (C. Van Horne, J. M. Wachowicz, 2008, p.462). Tax shield for CCA is calculated with simple formula:
Tax shield = CCA * Tax rate
E. g. in year one capital consumption allowance is £10,000 and the tax rate is 36%, so tax shield will be: £10,000 * 0.36 = £3,600
£3,600 must be added to company's cash flows, but this amount is estimated to be received in one year, which means that it has different present value according to discount rate. In year one, discount rate at 10% is 0.9091 and present value of future tax shield will be: £3,600 * 0.9091 = £3272.73
Net present value method is used in evaluating investments whereby the net present value of all cash outflows (such as cost of the investment) and cash inflows (returns) is calculated using a given discount rate usually a REQUIRED RATE OF RETURN. An investment is acceptable if the NPV is positive. In capital budgeting, the discount rate used is called the hurdle rate and is usually equal to the INCREMENTAL COST OF CAPITAL (J. Downes et.al. 2003.p.616)
In a multi-period situation NPV can be found by the following formulas:
In this particular situation, where tax shield is added, NPV formula will be calculated in following way:
where: t = the net cash flow at the end of year t;
= tax shield at the end of year t;
Inv0 = the initial investment outlay at t=0;
r = the discount rate based on the opportunity cost of capital;
n = the project's expected life-cycle
As total present values of cash flows and tax shields has been already calculated, it can be used directly in Net Present Value formula:
NPV=PVcash flow +PVtax shield-Invo
NPV for current project is negative and LSC Corporation must not invest in this project, because it will not achieve desired goals in desired time.
To conclude, it is important to analyze all committed calculations to make decision whether accept project or not. This situation shows how important is to do NPV analysis to make right decision and invest money properly.