Cost Benefits Analysis Example - Free Download | Page 6
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C o s t B e n e f i t A n a l y s i s t o o l k i t ( v 2 )
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The present value for 0 years is always 1, and this is not included in the present value table.
If you are looking to find the present value of £ 150,000 which you expect to receive in 5 years time,
at a rate of interest of 3%, the following steps are taken:
• Step 1 Use a NVP lookup table (see separate spreadsheet: net_pres_value.xlsx) and find the
relevant number of years (5 years in this example).
• Step 2 Look across the row for relevant the rate of interest (3% in this example).
• Step 3 Take the value you have found from steps 1 and 2 (in this case this is 0.863 and
multiply the present amount (£150,000) = £129,450.
NPV Illustration
On its own, this doesn’t tell us much, so you’d then use this against your projected cash flows or
savings/profits, e.g.
Year
Cash Flow (£)
3%
Discount Rate
Present Value (£)
0
(
150,000
)
1.000
(
150,000
)
1
12,
000
0.971
1
1,652
2
25,
000
0.943
23,575
3
25,
000
0.915
22,875
4
35,
000
0.888
31,080
5
40,
000
0.863
34,520
Net Present Value
26,298
A positive NPV means that the project is worthwhile because the cost of tying up capital is
compensated for by the cash inflows that result. When more than one project is being appraised,
you choose the one that produces the highest NPV.
3.4 Internal Rate of Return (IRR):
Sometimes we will want to know how well a project will perform under a range of interest rate
scenarios. The aim with IRR is to answer the question: “What level of interest will this project be able
to withstand” Once we know this, the risk of changing interest rate conditions can effectively be
minimised (especially in the current climate!).
The IRR is the annual percentage return achieved by a project, at which the sum of the discounted
cash inflows over the life of the project is equal to the sum of the capital invested.
Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
Imagine a scenario where we are considering whether to accept or reject an investment project, on
the basis of their acquiring the funds necessary at a known rate of interest.
•
The NPV approach asks if the present value of cash inflows less the initial investment is
positive, at the current borrowing rate.
•
The IRR approach asks if the IRR on the project is greater than the borrowing rate.
Illustration of NPV & IRR
For example, using the above NPV illustration of a £150,000 project yielding a NVP of £26,298
we
know that the project seems worthwhile (positive result)
