9609 · 10.3.3
Discounted cash flow method: net present value (NPV) flashcards
Revision flashcards for Cambridge 9609 Discounted cash flow method: net present value (NPV) (syllabus 10.3.3). Flip, recall, then mark a real past-paper question.
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Time value of money?
Money received sooner is worth more because it can earn a return; future cash must be discounted.
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Discount factor formula?
DF = 1 ÷ (1 + r)^n where r = cost of capital (decimal) and n = year.
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NPV formula?
NPV = Σ (PV of net cash flows) − Initial investment.
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NPV decision rule?
Accept if NPV > 0; reject if NPV < 0; indifferent if NPV = 0.
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Cost of capital in NPV?
The required return / discount rate reflecting risk and cost of finance.
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Why NPV preferred over payback?
NPV accounts for timing and size of all cash flows; payback ignores both after recovery and time value.
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Mutually exclusive projects?
Choose the project with the **higher NPV** (if both positive and only one can be done).
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Negative NPV meaning?
Project earns less than the required return — destroys shareholder value at that discount rate.
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What is the 'time value of money'?
The principle that a specific sum of money is worth more today than the same sum in the future, due to its potential earning capacity (opportunity cost) and the effects of inflation.
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What is the NPV decision rule for a single project?
If the NPV is positive, accept the project. If the NPV is negative, reject the project. If the NPV is zero, the project is borderline acceptable as it meets the minimum required rate of return.
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How is the Present Value (PV) of a future cash flow calculated?
Present Value = Future Cash Flow × Discount Factor. The discount factor is found using the formula 1 ÷ (1 + r)^n, where 'r' is the discount rate and 'n' is the number of years.
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Why is the initial investment (Year 0 cash outflow) not discounted in an NPV calculation?
Because the initial investment is a cash flow occurring 'today' (at the start of the project, Year 0), it is already in its present value form. Discounting is only applied to future cash flows.
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What is a major criticism of the NPV method?
Its high dependency on two key estimates: future cash flows and the discount rate. Small changes in either of these can significantly alter the NPV result and the investment decision, and both are difficult to predict accurately.