Question

Assuming that you are working in a company in Hong Kong and have to explain how time value of money should be considered in making investment decisions in the company.

Design and describe an investment or a project to be considered in your organization, which could be any kind of investment or project that you are interested in. Identify and explain the data you needed for calculating the net present value of the investment. Make assumptions to the data you needed and demonstrate TWO calculations, in which one results in accepting the investment and one results in rejecting the investment, with explanations.

Your final grade is given according to the design of your investment/project, the data you provided, the calculation and your recommendation of the investment.

Answer 1

Time value of money is important because the value of money falls with time. For a successful investor it is not only important to calculate how much money he will make but the timings of when those returns are received. Money today is more than money tomorrow.
If we have the option of getting $100 today or 5 years from now. Which is better? Of course now because the purchasing power of money falls. Whatever we could purchase from $50 now we could purchase the same thing 5 years later.
Due to the time value of money, we discount our cash flows. For each inflow, we want to know what is the value of each cash inflows in today’s term.

Net present value is the difference between the present value of cash inflows and cash outflows. All the present value of expected cash inflows are added and cash outflow is then subtracted from it.

Positive NPV: Accept the project.

Negative NPV: Reject the project.

For converting a future value of cash inflow to present value of cash inflow we use the formula

Present value = 1/(1+r)n

n = number of years

r = interest rate

If I am working in a company and I have to make a decision which machinery to buy A or B so for that first we have to estimate the cash inflows from the machinery and cost of capital and then we have to convert all the future cash inflows into present cash inflows with the help of the formula given above. If NPV comes positive then we will accept the machinery and reject if negative NPV comes.

DATA NEEDED FOR CALCULATING NPV

Initial investment: It is the amount required to buy any asset or for making any investment.

Cash flows: It is a series of money which company receives or pays

Discount rate: It is the rate of return that investor expects or cost of borrowing.

Time period : It is the life of an investment or project.

Using the table given below I will compute the net present value of both machines A and B and determine whether which machinery should be accepted or rejected. Assume that the cost of capital is 9%.
At the end of 3 years, the scrap value of machinery A is $20 and machine B is $25.

MACHINERY A                                                            MACHINERY B

YEAR             CASH FLOW                                       YEAR                   CASH FLOW

0                     -$100                                                    0                            -$200

1                     25                                                           1                            $40

2                     50                                                           2                            $60

3                     75                                                           3                            $85

MACHINERY A

YEAR	CASH FLOW	DISCOUNTING FACTOR AT 9%	PRESENT VLUE OF CASH FLOW
0	($100)	-	($100)
1	$25	0.917	22.94
2	$50	0.842	42.1
3	$75	0.772	57.91
3(SCRAP VALUE)	$20	0.772	15.44
NET PRESENT VALUE = 38.39

For machinery A the initial investment is $100 (given in red because it is a negative value) and the life of machinery is 3 years and after that, the scrap value is $20. For each year the future cash inflow is estimated and to convert it to the present value we multiply it with discounting factor (calculated by using the above formula). We add all the present cash inflows and deduct the cash outflow from it. Here we get the POSITIVE NPV so machinery A will be ACCEPTED.

MACHINERY B

YEAR	CASH FLOW	DISCOUNTING FACTOR AT 9%	PRESENT VLUE OF CASH FLOW
0	($200)	-	($200)
1	40	0.917	36.69
2	60	0.842	50.52
3	85	0.772	65.62
3(SCRAP VALUE)	25	0.772	19.30
NET PRESENT VALUE = ($27.87)

For machinery B the initial investment is $200 (given in red because it is a negative value) and the life of machinery is 3 years and after that, the scrap value is $25. For each year the future cash inflow is estimated and to convert it to the present value we multiply it with discounting factor ( calculated by using the above formula). We add all the present cash inflows and deduct the cash outflow from it. Here we get the NEGATIVE NPV so machinery A will be REJECTED.

we will choose machine A over B because machine A has positive NPV.