Investment Appraisal

Investment Appraisal

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I am assessing the viability of an investment using NPV and IRR. This is working well and giving me the answers I'm looking for, however, I would like to run the scenarios with a geared investment and this is where I being to lose the plot. Am I correct to show a reduced investment? For example, in a scenario where there is a loan of 50% the investment reduces from £60k to £30k; I then show interest costs and the tax effect of that to give an overall better rate of return.

If that was a 100% geared investment then I cannot arrive at an IRR because there is no initial investment.

Do, please, correct my understanding.

Many thanks.

Phil

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By brianheg
02nd Oct 2012 12:12

Real vs nominal

In general, IRR and NPVs exclude financing. However, you can include the net cash flows to the holders of equity in order to do an IRR / NPV on just the equity return. Be careful to be consistent - if you're using real cash flows you should only have a real interest rate for the return on debt. If you're using the actual interest rate you need to have nominal / indexed cash flows.

If there is no equity investment (100% debt) the returns are infinite, so it's quite a good investment!

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By AdShawBPR
12th Oct 2012 18:31

NPV/IRR

agree with brianheg.  Would add that you should be a little careful with the excel functions if that's what you're using.  I prefer to use actual cash flows and solve for a NPV or IRR to get the balance to fall to zero.  You can use the excel functions to provide what should be the answer (so no 'solving' required) but if it's incorporated into a cash flow, the balance should fall to zero.  Easier to spot errors in a cash flow.  Probably not very well explained!

Other thing to watch out for is tax.  If tax is neutral can ignore, but may not be (e.g. equipment/lease analysis) in which case you need to make sure your pre-tax or post-tax discount rates consistently applied.

The high leverage and high return is exactly what got the bankers excited and then got all of us into trouble.

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