A man buys a taxi for £31,000. He plans on driving it around for five years as a full-time profession. The average salary for a taxi driver is somewhere between £15,000-30,000 per annum; therefore, we’ll take £22,500 as the salary he can expect to earn.
AAT students at levels 3 and 4 will need to use investment appraisal techniques to work out whether projects like this are worthwhile. Today we look at the Net Present Value technique to see if our taxi driver can expect a good return on his investment.
The Initial Outlay and The Positive Cash Flow
The initial outlay of the investment is the taxi – that’s a hefty £31,000. The taxi driver’s salary of £22,500 is what’s called the ‘positive cash flow’. We don’t need a calculator to understand that by the end of the second year, the taxi driver will have made a profit, right? But the value of currency falls over time, meaning the longer we wait to receive a cash flow, the less that cash flow is worth.
The Net Present Value Approach
The Net Present Value approach to investment appraisal takes into account the shifty nature of currency by adding time into the equation. The longer we wait for our positive cash flow, the slower we pay back on that initial outlay. Remember, the initial outlay is locked in the time it was paid for, unlike the positive cash flow, which is time dependent.
To find the ‘real’ value of a cash flow over time, accountants must reduce the value by multiplying the cash flow by ‘the discount factor’: a decimal that reflects the falling price of currency. This decimal is calculated by looking at the interest rates over time. We’ll take 5% as our interest rate for each year of our appraisal. By multiplying the ‘cash flow’ by the ‘discount factor’ we get the ‘present value’ of the cash flow which can be considered a more accurate (but not the most accurate) representation of what return we can expect from our investments over time.
Year Discount Factor (5% Interest Rate per year)
Year 1 0.952
Year 2 0.907
Year 3 0.864
Year 4 0.823
Year 5 0.784
The ‘present value’ of year one’s cash flow is: £22,500 X 0.952 = £21,420
Year two is: £22,500 X 0.907 = £20,407.50
Here we see the ‘time value of money’. But, to work out the ‘net present cash flow’ of an investment we combine the ‘present value’ of each year with the negative cash flow of the initial outlay (the £31,000 taxi, remember). This will indicate the success of the investment over a period of time, and in turn will help accountants inform decision makers whether the initial outlay is worth its price.
(£31,000 initial outlay) + £21,420 (year 1) + £20,407.50 (year 2) + £19,440 (year 3) +
£18,517.50 (year 4) + £17,640 (year 5) = +£66,425
The overall net present value over five years is positive. A good deal for our taxi driver.