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A Review Of The Discounted Cash Flow Techniques On Investment Appraisal Of

2550 words - 11 pages

Question 1:
Accountants make a distinction between Capital Expenditure and Revenue expenditure
(Dyson, 2007). Dyson further says capital expenditure provides benefit to an entity for more
than one year, while revenue expenditure does so for one year. Drury (2005) refers to
expenditures of a capital nature as Capital Investments describing them in the same manner
as Dyson. Collin (2007) defines investment appraisal as an analysis of the future probability
of capital purchases as an aid to good management. In this essay, we are going to discuss
investment appraisal, supporting the argument that investment appraisal should add value to
the organisation. We are also going to analyse ...view middle of the document...

The idea of value creation is to capitalise on what, as an organisation, you are out for. The
organisation may be a business, a school, a corporation or a government department. For
example, to create value for its shareholders, a profit making business will only invest in
projects that yield a rate of return greater than the company's cost of capital. In the same way,
to create value for members of its community, a community run health centre will choose to
invest scarce capital resources only on projects that enhance the health and medical
conditions of members of the community.
Organisations serve a purpose. They exist to deliver certain services / values. Therefore the
activities of the organisation should be geared towards achieving the purpose for which it
exists. To achieve its objectives, an organisation makes use of tremendous amount of time,
effort, finance and other resources, and so it makes perfect sense to ensure judicious
utilization of these resources. The purpose of Investment Appraisal as an aid to management
is to ensure that management commits capital resources only to those projects that will create
or add value to the organisation.
Therefore, to attain its very goals and objectives, every investment appraisal effort by an
organisation should be geared towards selecting the best alternative that will add the most
value to the organisation by creating value for either its shareholders (for businesses) or
customers (for businesses) or members (for clubs and societies) or beneficiaries (for
charities), etc.
For the rest of this essay, we are going to discuss the two main discounted cash flow (DCF)
methods of investment appraisal available to management.
'Discounted cash flow techniques take account of the time value of money. This means
that they take into account the fact that £1 now is worth more than £1 received in the
future, because £1 received now can be invested and made to grow bigger as time
(Walker, 2009)
Dayanada et al (2002) identify two discounted cash flow methods, namely the Net Present
Value (NPV) method and the Internal Rate of Return. They go further to outline three basic
assumptions that underlie these DCF techniques, namely:
1. There is a single goal of wealth maximization for the firm:
2. All cash inflows and outflows of the project are known with certainty
3. There are no resource constraints (all the profitable projects can be accepted [and
NPV and IRR are used in both Accept / Reject decisions and Ranking decisions.
The Net Present Value (NPV) of a project is the Present Value of cash inflows over the life
the project less the present value of cash outflows. Present value can be described as the
value, now, of future cash flows. Drury states that the process of converting future cash flows
into a value at the present time by use of an interest rate is termed discounting. He provides
the following formula for present value:
PV = FV x OR

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