Investment appraisal techniques
Discounting cashflow methods
Discounting cashflow allows you to put cashflows received at different times on a comparable basis - see discounting future cashflow.
You can use discounting cashflow to evaluate potential investments. There are two types of discounting methods of appraisal - the net present value (NPV) and internal rate of return (IRR).
Net present value (NPV)
The NPV calculates the present value of all cashflow associated with an investment: the initial investment outflow and the future cashflow returns. The higher the NPV the better. For example, if an investment of £100,000 generates annual cashflow of £28,000 and you discount at 10 per cent, the NPV for five years of cashflow is £6,142.
However, if the annual cashflow starts at £26,000 and goes up by £1,000 a year, giving the same total amount of cash over five years - £140,000 - the NPV, using a discount rate of 10 per cent, will be £5,422.
Internal rate of return (IRR)
As an alternative, you can work out the discount rate that would give an investment an NPV of zero. This is called the IRR. The higher the IRR the better. You can compare the IRR to your own cost of capital, or the IRR on alternative projects.
The key advantage of NPV and IRR is that they take into account the time value of money - the fact that money you expect sooner is worth more to you than money you expect further in the future.
Disadvantages of net present value and internal rate of return
NPV and IRR are sophisticated and relatively complicated ways of evaluating a potential investment. Most spreadsheet packages include functions that can calculate these or you could ask your accountant for help - see help with investment appraisal.
Choosing the right discount rate to use to calculate NPV is difficult. The discount rate needs to take into account the riskiness of an investment project and should at least match your cost of capital.