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Project costs - NPV analysis

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I am looking at starting to review project costs and payback in more detail and was looking at implementing a simple model which can be used going forward.

I have looked into Payback/IRR and NPV method. Payback is fairly simple to implement, however it does ignore future cashflows and value of money. 

Therefore, i feel that NPV would be the best option, however i am struggling with calculating discounting factor. During studies, these have always been provided and i've looked at other sources and all i can find is the examples with the known discounted factor. I was wondering if it is sensible to use inflation rate as a substitue for discounted rate? Or would any one be able to please direct me with calculating discounted factor? 

Thank you!

Replies (10)

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By alfredpennypinch
24th Jun 2022 17:31

The formula for calculating a discount factor = 1 / (1 * (1 + Discount rate) ^ period number).

Remember to match the discount rate with the period - so if you're doing annual cashflows then you use an annual discount rate, if monthly cashflows then use a monthly discount rate.

It might be easier to use the XNPV function in Excel.

As to which rate to use, it's supposed to be the rate of return your investors expect/the cost of raising the project finance depending on the source of the funds. The rate of inflation is unlikely to cut it.

Thanks (2)
By Bobbo
24th Jun 2022 18:11

As well as Alfred's point about cost of capital being the basis for your discount rate, you may need to factor inflation into your discount rate too.

If inflation is 9%, a project generating an annual return of 9% is in real terms generating a return of 0%.

Thanks (1)
By Paul Crowley
24th Jun 2022 20:23

The whole point of having different measures is that there is not one BEST measure
This stuff comes straight out of study manuals using known cash flows
Real life, everything is a guess
My guess? Best to learn from those who have 10 years experince in the working world making real decisions with real consequences.
I studied this stuff 40 years ago
Never bothered with it since

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Replying to Paul Crowley:
By lionofludesch
24th Jun 2022 23:55

Utter theoretical claptrap, the usefulness of which is directly proportional to your ability to guess the discount rate.

Though I'm not against other folk using it.

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By paul.benny
26th Jun 2022 09:05

What's the expected lifetime of your projects? Unless there an unusual cashflow pattern, or payback is >5 years, payback is always the first and arguably best measure. Everyone understands it, and everyone understands that long payback periods carry greater uncertainty.

As Paul C says, in exams, in study manuals, the cashflows are always provided; in real life, they're estimates and highly uncertain.

NPV and IRR can be good for choosing between different projects. But what discount rate/hurdle rate to use? Again the manuals give you neat answers or neat methods for determining the rate. Inflation alone doesn't take account of the opportunity cost (the funds could have been earning interest/nor incurring interest).

In my view, the effort should go into testing and validating the cost and revenue assumptions. I've often seen machines take far longer than anticipated to reach full production, new product sales take years to reach projected volumes and costs that are over-optimistic.

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Replying to paul.benny:
By NatBee
27th Jun 2022 08:40

Thank you, your reply is very helpful!

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By tom123
26th Jun 2022 16:20

I was very excited the other year to use NPV for the first time in my working life - and had to remember approximately 25 years back to when I learned it.

If I had a project to appraise right now I would use a few measures.
and something else if it made sense.

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Replying to tom123:
paddle steamer
27th Jun 2022 11:11

I have only ever used once in 37 years;-we have an agreement that pays out 12,000 per year to a third party for a number of years (2004-2028) and a schedule is attached to the agreement stating at each anniversary date the buyout price (NPV) which was calculated using a 4.75% rate., that is it.

Real waste, I spent weeks and weeks on business finance, I even got a merit for it at Uni, (I still own my Samuels and Wilbes plus also an updated version) I used to be able to write the mathematical proof from my head of one of Modigliani and Miller's exotic constructs (not these days), yet it, like my stellar studies of accounting theories for inflation ,have all really been a total waste of time.

By chance we have been clearing paperwork in the house this weekend ( preparing maybe for an Edinburgh departure when we retire), doing this I came across the Aberdeen University Accountancy Special syllabus ( a one year PG crash course I took in 84-85) in amongst my old ICAS paperwork/experience book .

Thinking about it I suspect I have now forgotten more accounting and finance than I currently know-scary.

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Replying to DJKL:
By Hugo Fair
27th Jun 2022 11:56

Just imagine - if you'd known back then what you'd never actually *need* to know ...
helps define whether you're an innate optimist ('if only' said with a glazed smile) - or pessimist ('aaargh' screamed at full volume)!

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Replying to Hugo Fair:
paddle steamer
27th Jun 2022 13:47

Catch with accounting is whilst there are technical bits within specific areas that can be learned (though in my case these days usually only just when needed), and yes, tax is murky and finicky, notwithstanding the foregoing the essence of the thing is you really need people skills , common sense, healthy scepticism and an understanding of debits and credits.

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