This balance means that the course of action is financially beneficial, ethical, and acceptable to the majority of stakeholders (Boatright, 2010). Net Present Value Analysis Investment appraisal is an important step in making financial decisions. The net present value (NPV) model is one of the tools used in investment appraisal and can simply be defined as the sum of the discounted cash flows less than the initial investment (Chambers, 1967). This is a superior tool that takes into account the concept of the time value of money. This concept appreciates the fact that a dollar today is worth more than a dollar tomorrow.
This is incorporated in the NPV calculation by the discounting process; it involves the use of an appropriate discounting rate to discount cash flows to present value (Chambers, 1967). These discount rates can be calculated by adding one to the discount rate and raising it to the power of (negative) time in years. In the case of city energy, at a discount rate of 8% year three’ s discount factor will be 0.7938 (1.08^-3). Discounting factors are also available directly from mathematical tables. It is important that only relevant costs are included in the NPV calculations.
Irrelevant costs include; sunk costs, non-monetary costs, costs not wholly and exclusively incurred as a result of the investment decision, committed costs, and unavoidable costs (Jean, 1973). These costs should be ignored and excluded from the NPV calculation. In the case of City Energy, the expenditure of $750,000 that has already been spent on an assessment exercise to identify key issues, is a sunk cost and should be ignored. The NPV model only takes into account future cash flows and hence costs that have already been incurred must be ignored. NPV: Option to Retain Function In-House The relocation cost incurred in year zero is relevant as it is incurred as a result of the financial decision.
If City Energy decided to outsource this function the $100,000 incurred for relocation can be avoided. This cash flow is assumed to occur at year zero and hence it is not discounted. The rental costs are relevant costs and are included in the NPV calculation. These costs are constant and the cash flows are assumed to occur at year-end. Additional and replacement costs are relevant costs and form part of the NPV calculation.
$1.75 million is expected to be incurred at year zero while $0.5 million is expected to be incurred in year 2 (after 3 years). Cash inflows of $100,000 are expected to be realized as the salvage value, this is the only cash inflow in the case of City Energy. This cash inflow is assumed to be occurring at the end of the ten year period. Staffing costs and other operating costs are relevant costs.
They are both expected to increase over the period at the rate of 3% and 5% respectively. The cash outflows at year one relating to staffing costs are $2 million while outflows relating to other operating costs are expected to be $0.5 million at year one. These cash flows should be inflated from year two going forward. Both depreciation and interest costs should be ignored and excluded in the investment appraisal. Depreciation is a non-cash item and therefore irrelevant. Depreciation is an accounting tool that tries to systematically match the cost of an asset to the cash flows it helps generate (Rees, 1995).
Only tax allowable depreciation is relevant as it gives rise to relevant cash flows inform of tax allowances. Finance costs are taken care of by the discounting process. The discounting factor should represent the firm’ s cost of finance; interest costs affect the firm's cost of capital. Including the finance costs in the NPV calculations would amount to double counting and this would be misleading (Cooper, 1985)
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