Net Present Value (NPV) is one of the investment appraisal techniques which is regularly examined in the financial management papers (F9 & P4).
NPV questions are easy to score marks from – when you know how. For a number of students, I understand that their difficulty in answering NPV questions correctly stems from not understanding the purpose for NPV calculations, and trying to cram an NPV ‘formula’. This often results in confusion, if the exam question is worded differently from their crammed formula.
NPV questions usually require a number of separate calculations, which can seem tedious and time consuming and confusing when not properly understood. Easy marks can be gained from writing-out calculations for capital allowances, tax, cash flows, and variable costs, and stating your assumptions.
In order to better explain NPV, this topic will be split into 3 parts. We shall also work with ACCA past questions for F9. I suggest you download and print out F9 June 2009 and F9 June 2013 here
Basic NPV Knowledge:
Most NPV questions will require you differentiate relevant and irrelevant costs. Relevant costs are those pertaining to the future of the project/investment, and irrelevant costs (aka sunk costs) are those that have already been expended (e.g. research & Development, fixed costs), or will be expended anyway, regardless of whether the project/investment is undertaken or not.
Fixed costs aren’t generally included as relevant cash flows, but when fixed costs are affected by inflation, it is acceptable to include it.
As a general rule, add cash flows that increase the value of the project/investment, and subtract those which are expenses on the project.
Depreciation is an irrelevant cost, as it does not reflect actual cash flow from the project
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