CHAPTER SIX

INVESTMENT EVALUATION AND BASIC

ACCOUNTING PRINCIPLE
Content:
Time value of money
Projects financing
Financial evaluations

1
 Time Value of Money
What is Time Value?
We say that money has a time value because that money
can be invested with the expectation of earning a positive
rate of return

In other words, “a birr received today is worth more than a

birr to be received tomorrow

That is because today’s birr can be invested so that we

have more than one birr tomorrow

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 Terminology of Time Value
Present Value (PV) - An amount of money today, or the current
value of a future cash flow

Future Value (FV) - An amount of money at some future time period

Period - A length of time (often a year, but can be a month, week,

day, hour, etc.)

Interest Rate(I) - The interest rate per period. The compensation

paid to a lender (or saver) for the use of funds expressed as a
percentage for a period.

CF – Cash Flow at any time, t

3
 Time Lines
0 1 2 3
I%

CF0 CF1 CF2 CF3

Show the timing of cash flows.

Time 0 is today; Time 1 is the end of the first period (year,

month, etc.) or the beginning of the second period.

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 The Interest Rate
Which would you prefer $10,000 today or $10,000 in 5 years?
years

Obviously, $10,000 today.

today you already recognize that there is
time value to money!!
money
Types of Interest
1. Simple Interest:
Interest: Interest paid (earned) on only the original
amount, or principal, borrowed (lent).

2. Compound Interest:
Interest: Interest paid (earned) on any previous
interest earned, as well as on the principal borrowed (lent).
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 Simple Interest Formula
Formula
SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n:Number of Time Periods

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 Simple Interest Example
Assume that you deposit $1,000 in an account earning 7%
simple interest for 2 years. What is the accumulated interest
at the end of the 2nd year?
SI = P0(i)(n)

SI = $1,000(.07)(2)

SI = $140
What is the Future Value (FV
FV) of the deposit?

FV = P0 + SI
FV = $1,000 + $140
7 FV = $1,140
Example :ABC lends a sum of $5000 at 10% per annum for a period of
5 years. Compute the Simple Interest and total amount due after 5 years.
Solution:

Given: Principal: $5000

Interest Rate: 10% per annum
Time period (in years) = 5
Then :

Simple Interest Formula = Principal * Interest Rate * Time Period

Simple Interest=$5000 * 10%*5

=$2500
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 Simple Interest (FV)
Future Value:
Value: is the value at some future time of a
present amount of money, or a series of payments,
evaluated at a given interest rate.
What is the Present Value (PV
PV) of the previous problem?

The Present Value is simply the $1,000 you originally

deposited. has is the value today!

Present Value is the current value of a future amount of

money, or a series of payments, evaluated at a given interest
rate.
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 Compound Interest
Future Value of a Single $1,000 Deposit

20000
10% Simple
15000 Interest
Future Value (Birr)

10000 7% Compound
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year

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 Future Value Single Deposit
Assume that you deposit $1,000 at a compound
interest rate of 7% for 2 years.
years

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 Future Value Single Deposit (Formula)

FV1 = P0 (1+i)1
= $1,000 (1.07)
= $1,070
Compound Interest

You earned $70 interest on your $1,000 deposit over

the first year.

This is the same amount of interest you would earn

under simple interest.
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 General Future Value Formula

FV1 = P0(1+i)1

FV2 = P0(1+i)2

etc

General Future Value Formula:

FVn = P0 (1+i)n
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 Examples
1. What is the future value (FV) of an initial $100 after 3
years, if I/YR = 10%?

0 1 2 3

10%

100 FV = ?

14 14
 Solving for FV: the step-by-step and formula methods
After 1 year:
FV1 = PV (1 + I) = $100 (1.10)
= $110.00
After 2 years:
FV2 = PV (1 + I)2 = $100 (1.10)2
= $121.00
After 3 years:
FV3 = PV (1 + I)3 = $ 100 (1.10)3
=$133.1
After N years (general case):
15
15 FVN = PV (1 + I)N
 General formula

This formula can be generalized to:

where FV is the future amount, P is the principal, r is the
interest rate as a decimal, m is the number of compounding
periods in one year and t is the total number of years. To
simplify
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the formula,
 2. What is the present value (PV) of $100 due in 3 years,
if I/YR = 10%?
Finding the PV of a cash flow or series of cash flows is
called discounting (the reverse of compounding).

The PV shows the value of cash flows in terms of today’s

purchasing power.
0 1 2 3

10%

PV = ? 100

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 Solving for PV: the arithmetic method
Rearranging the equation:
FVn = PV ( 1 + i )n,
we can solve for PV to get:
PV = FVn / ( 1 + i )n

Now solve the general FV equation for PV:

PV = FVn / ( 1 + i )n
PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13
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 Investment Appraisal
A means of assessing whether an investment project is valuable or not.
There are different types of investment appraisal techniques.

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 1. Payback Period

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 1.Payback period method
The length of time taken to repay the initial capital cost. Requires
information on the returns the investment generates.

In Case of Even Cash Flows

Example: A machine costs of £600,000, It produces items that

generate a profit of £5 each on a production run of 60,000 units per
year. Calculate the payback periods .

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Payback Method with uneven cash inflow
E.g. Cost of machine = £450,000
Income Cumulative
Cash flow

Year 0 (£450,000)

Year 1 £50,000
Payback =
Year 2 £70,000

Year 3 £100,000

Year 4 £130,000

Year 5 £200,000

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 Payback Method with uneven cash inflow
E.g. Cost of machine = £450,000, Payback = 5 year
Income Cumulative Cash flow

Year 0 (£450,000)

Year 1 £50,000 (400,000)

Year 2 £70,000 (330,000)

Year 3 £100,000 (230,000)

Year 4 £130,000 (100,000)
Year 5 £200,000 100,000

Decision Criterion
Shorter the payback Period – Accept the project
Longer the payback period – Reject the project
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 2. Accounting Rate of Return

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 2. Accounting Rate of Return
A comparison of the profit generated by the investment
with the cost of the investment.

Average annual return or annual profit

ARR = --------------------------------------------
Initial cost of investment

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 Accounting Rate of Return ( ARR)
E.g. An investment is expected to yield cash flows of £10,000
annually for the next 5 years. The initial cost of the
investment is £20,000, Calculate the value of ARR.
Solution:
Total profit =(5x£10,000) - £20,000 = £30,000
Annual profit = £30,000 / 5 = £6,000

ARR = 6,000/20,000 x 100

= 30%

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 Activity on ARR
Construction A is considering 2 projects. Using the ARR
approach decide which is the better investment.
Project A Project B

Initial investment -£10,000 -£20,000

Year 1 cash receipt £4,000 £9,000

Year 2 cash receipt £5,000 £9,000

Year 3 cash receipt £5,000 £12,000

Year 4 cash receipt £4,000 £10,000

Total cash receipt (1)

Profit over 4 years (2)

Average annual profit (3)

Accounting Rate of Return (4)

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Activity on Accounting Rate of Return
Construction A is considering 2 projects. Using the ARR approach
decide which is the better investment.

Project A Project B
Initial investment -£10,000 -£20,000
Year 1 cash receipt £4,000 £9,000
Year 2 cash receipt £5,000 £9,000
Year 3 cash receipt £5,000 £12,000
Year 4 cash receipt £4,000 £10,000
Total cash receipt £18,000 £40,000
Profit over 4 years £8,000 £20,000
Average annual profit £2,000 £5,000
Accounting Rate of £2,000 X 100 £5,000 X 100
Return
20%
£10,000 25%
£20,000
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 Decision Criterion:
Higher the ARR or ARR above minimum expected rate of
return – Accept the project

Lower the ARR or ARR below minimum expected rate of

return – Reject the project

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 Net Present Value (NPV)

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Net Present Value
Takes into account the fact that money values change with time.

How much would you need to invest today to earn x amount in

n years time?
Value of money is affected by interest rates

NPV helps to take these factors into consideration

Shows you what your investment would have earned in an

alternative investment regime
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 Net Present Value
E.g. Project A costs £1,000,000, After 5 years the cash
returns = £100,000, (10%) If you had invested the £1
million into a bank offering interest at 12% the returns
would be greater. You might be better off re-considering
your investment!

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Net Present Value
principle:
How much would you have to invest now to earn £100 in
one year’s time if the interest rate was 5%? The amount
invested would need to be: £95.24

Allows comparison of an investment by valuing cash

payments on the project and cash receipts expected to be
earned over the lifetime of the investment at the same point
in time, i.e. the present.
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 Net Present Value
Future Value
PV = -----------------
(1 + i)n
Where i = interest rate

n = number of years

The PV of £1 @ 10% in 1 years time is 0.9090.If you

invested 0.9090p today and the interest rate was 10% you
would have £1 in a year’s time. Process referred to a
‘Discounting Cash Flow’
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 Net Present Value
present value = Cash flow x discount factor

E.g. PV of £500 in 10 years time at a rate of interest of

4.25% = 500 * 0.6595373 = £329.77

£329.77 is what you would have to invest today at a

rate of interest of 4.25% to earn £500 in 10 years time.

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 Example
XYZ company is starting the project at cost of $ 100,000. The
project will generate cash-flow of $ 40,000 , $ 50,000 & $ 50,000 in
year 1, year 2 & year 3 respectively. Company’s WACC is 10%.
Find out NPV.

solution
Formula of NPV = [ $40,000/( 1+0.1)1] + [ $ 50,000 / (1+0.1)2 ] +

[ $ 50,000/ (1+0.1)3 ] – 100,000

Net present value = ($ 36,363.63 + $ 41,322.31 +$ 37,565.74) – $ 100,000

Net present value = $ 115,251.68 – $ 100,000

The net present value of the project is $ 15,251.68.

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 Decision Criterion
NPV is Positive – Accept the project

NPV is Zero or Negative – Reject the project

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 Profitability index (PI):
Profitability index (PI):is the ratio of payoff to investment of
a proposed project.

It is a useful tool for ranking projects because it allows you to

quantify the amount of value created per unit of investment

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Example : Company C is undertaking a project at a cost of N50
million which is expected to generate future net cash flows with a
present value of N65 million. Calculate the profitability index.
Solution

Decision Criterion
PI Index is greater than 1 – Accept the project
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PI Index is lesser than 1 – Reject the project