Interactive Business Simulation
Finance: Investment Appraisal using Discounted Cash Flow
Note: this interactive simulator is designed to be viewed using an up-to-date internet
browser. Users must also have Macromedia Flash Player Version 6 or 7 installed
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Introduction
This worksheet supports the new tutor2u interactive business simulation on investment
appraisal. It will help you develop your understanding of the role of discounted cash flow
calculations in investment appraisal.
The use of discounted cash flows is just one method of investment appraisal. You may
have come across two other popular methods in your studies so far:
- Payback period: the simplest form of investment appraisal
- Average rate of return (“ARR”): a method that focuses on the average profitability of an
investment project
Neither the payback period nor the ARR method considers the impact of time and its
effect on the value of money. This is an important weakness since the length of time
over which investment returns are made affects the true value of those returns. For
example, inflation erodes the value of money. From an investment point of view,
£100,000 received today is worth more than £100,000 received in five years time.
Added to this is the opportunity cost of investing. Money not invested by a business in
an investment project could alternatively be invested in a bank where it would earn
interest. So any investment must generate better returns than the potential return from
merely investing money in the bank.
What is discounting?
At a simple level, to determine the true value of the investment returns from a project. An
interest rate (“discount rate”) is used to calculate a discounting factor. Future returns
from an investment are discounted (reduced) using these discount factors.
Sometimes a higher interest or discount rate is used to take account of the level of risk
involved.
Once the discounted returns from the project are calculated, these are added together to
calculate the net present value (“NPV”) of the project.
Where the NPV of a project is negative, the investment project would normally be
rejected.
When comparing alternative investment projects, the project with the highest NPV would
normally be chosen.
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Using the Simulator
You should now launch the interactive business simulator in your Internet browser:
http://www.tutor2u.net/assets/simulations/Investment_appraisal_simulator_v1.swf
The simulator provides an interface for you to:
- Select a discount rate
- Enter the projected cash flows associated with an investment project over a period of
up to seven years
- See the effect of applying the chosen discount rate to those project cash flows
- Determine whether a project should proceed using discounted cash flow techniques
Using the interactive simulator, complete the exercises provided.
At the end of this document you will also find answers to the exercises.
This free simulator is brought to you by tutor2u - the leading online resource for students
and teachers of economics and business studies. tutor2u’s website –
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Investment Appraisal Simulator – Exercises
Question
Your Answer
Exercise 1
The following questions relate to the initial data presented when the simulator first loads
in your browser. To reset the simulator to this data, simply place your mouse anywhere
on the screen and then click “Play” and then “Rewind”
How much is being invested in
the project?
What are the total cash returns
from the project?
At a discount rate of 10%, what
is the net present value (“NPV”)
of the project?
Based on the opening NPV of
the project, should the
investment be made?
What happens to the NPV of
this project if a higher discount
rate – 25% - is applied to future
cash flows?
Suggest two reasons why
management might want to use
a higher discount rate (say
25%) rather than a lower one
(say 10%)
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Exercise 2
Before answering these questions you need to rewind the simulation and then make the
following changes to the model settings:
- Set the discount rate to 10%
- Set all the cash outflows (red numbers) to zero
- Set all the cash inflows (blue numbers) to zero
When you have done this, follow the instructions given
Set an investment return in
Year 1 (cash inflow) to
£100,000. What is the “present
value” of this return using a
10% discount rate?
Why does the present value of
£100,000 received in Year 1
seem to be less than the actual
amount received?
Now increase the discount rate
to 20%. What is the new
present value of £100,000
received in Year 1?
What is £100,000 received in
Year 1 worth if the discount rate
is zero (0%)?
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Exercise 3
Before answering these questions:
- Reset all cash outflows (red numbers) and inflows (blue numbers) to zero
- Set the discount rate to 15%
When you have done this, read the following information carefully and reflect the
following investment project information in the simulator:
Bradfield Industrial Limited is considering investing in new plant and machinery.
£50,000 will be spent now in preparing factory space and £100,000 will be spent at Year
1 when the machinery is installed and operational. Management estimate the
investment will generate additional cash flows of £75,000 in each of Year 2 and 3, falling
to just £25,000 in each of Year 4 and 5. At that stage, the machinery will be scrapped at
nil cost.
What is the total investment in
this project?
What are the total returns from
this project?
What is the net present value of
the project at a 15% discount
rate
What happens to the NPV of
the project if the forecast cash
flows turn out to be lower than
expected – at just £50,000 in
Year 2 and 3 rather than
£75,000?
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Exercise 4
Before answering these questions:
- Set the discount rate to 0%
- Set the investment (cash outflows) to £50,000 at the START of the project
- Set the returns (cash inflows) to £15,000 in each of Year 1, Year 2, Year 3, Year 4 and
Year 5
What are the total investment
and returns using the above
information?
What is the net present value
(“NPV”) of this project at a zero
(0%) discount rate?
What is the NPV of the project
at a 10% discount rate?
To the nearest 1%, estimate the
discount rate that, when applied
to the forecast investment cash
flows, would make the NPV
equal to zero
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Exercises – Outline Answers
Question
Your Answer
Exercise 1
The following questions relate to the initial data presented when the simulator first loads
in your browser. To reset the simulator to this data, simply place your mouse anywhere
on the screen and then click “Play” and then “Rewind”
How much is being invested in
the project?
£100,000
What are the total cash returns
from the project?
£150,000
At a discount rate of 10%, what
is the net present value (“NPV”)
of the project?
£24,343
Based on the opening NPV of
the project, should the
investment be made?
Yes – since the NPV is positive
What happens to the NPV of
this project if a higher discount
rate – 25% - is applied to future
cash flows?
The higher discount rate means that the present value
of future investment returns falls. So the NPV falls.
In this case, the new NPV is a negative £2,400, which
suggests that the project should not be undertaken.
Suggest two reasons why
management might want to use
a higher discount rate (say
25%) rather than a lower one
(say 10%)
However, this return may need to be compared with
those of alternative projects too
(1) Because the future returns from this
investment are very uncertain – so they want
to reduce the importance of relying on future
cash inflows in making their investment
decision
(2) Because management have a high required
rate of return from investments and want to
ensure that projects only go ahead if they
meet high target returns
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Exercise 2
Before answering these questions you need to rewind the simulation and then make the
following changes to the model settings:
- Set the discount rate to 10%
- Set all the cash outflows (red numbers) to zero
- Set all the cash inflows (blue numbers) to zero
When you have done this, follow the instructions given
Set an investment return in
Year 1 (cash inflow) to
£100,000. What is the “present
value” of this return using a
10% discount rate?
£90,909
Why does the present value of
£100,000 received in Year 1
seem to be less than the actual
amount received?
Because the “present value” reflects the “time value of
money”. £100,000 is worth less to the business in
one year’s time than now, because if that money were
received now it could be invested to earn a further
return.
Now increase the discount rate
to 20%. What is the new
present value of £100,000
received in Year 1?
It falls to:
What is £100,000 received in
Year 1 worth if the discount rate
is zero (0%)?
£100,000
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£83,333
The use of a higher discount rate means that future
returns are worth less in the future (they are more
heavily discounted or reduced)
In other words, a discount rate of zero (0%) assumes
that there is no time value of money. Amounts
received at some point in the future are worth just the
same to the business then as if they were received
right now.
Exercise 3
Before answering these questions:
- Reset all cash outflows (red numbers) and inflows (blue numbers) to zero
- Set the discount rate to 15%
When you have done this, read the following information carefully and reflect the
following investment project information in the simulator:
Bradfield Industrial Limited is considering investing in new plant and machinery.
£50,000 will be spent now in preparing factory space and £100,000 will be spent at Year
1 when the machinery is installed and operational. Management estimate the the
investment will generate additional cash flows of £75,000 in each of Year 2 and 3, falling
to just £25,000 in each of Year 4 and 5. At that stage, the machinery will be scrapped at
nil cost.
What is the total investment in
this project?
£150,000
What are the total returns from
this project?
£200,000
What is the net present value of
the project at a 15% discount
rate
£15,703 Positive
What happens to the NPV of
the project if the forecast cash
flows turn out to be lower than
expected – at just £50,000 in
Year 2 and 3 rather than
£75,000?
The NPV falls to:
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(£50,000 + £100,000)
(£75,000 + £75,000 + £25,000 +£25,000)
I.e. the project should be accepted provided it
achieves an acceptable return compared with other
competing investment projects
£24,939 Negative
I.e. the project should be rejected
Exercise 4
Before answering these questions:
- Set the discount rate to 0%
- Set the investment (cash outflows) to £50,000 at the START of the project
- Set the returns (cash inflows) to £15,000 in each of Year 1, Year 2, Year 3, Year 4 and
Year 5
What are the total investment
and returns using the above
information?
Total investment: £50,000
What is the net present value
(“NPV”) of this project at a zero
(0%) discount rate?
£25,000
Total returns: £75,000 (i.e. 5 x £15,000)
i.e. total returns £75,000 less total investment of
£50,000
A zero (0%) discount rate assumes that the present
values are the same as actual cash flows.
What is the NPV of the project
at a 10% discount rate?
£6,862 Positive
To the nearest 1%, estimate the
discount rate that, when applied
to the forecast investment cash
flows, would make the NPV
equal to zero
A discount rate of 15% gives a NPV of £282 – as
close to zero as the simulator will allow.
This is also known as the Internal Rate of Return
(“IRR”) – the discount rate at which the present value
of total investment cash flows equals zero.
Think of the IRR as a form of target rate of return. If
the discount rate were higher than 15% then the NPV
would turn negative, making the project unattractive.
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