A friend asked me to summarise the key points on investment appraisal as he will be taking his exams in a couple of months’ time, so I built him a model to run through the logic.
- Only include relevant costs and revenues
- Make sure you correctly reflect the timing of future cash flows
- Deal with taxation (you’re gonna have to!)
Costs and revenues should only be taken into account when they are a direct result of the decision being made. Leave out sunk costs and anything else which will not be affected by your decision or would happen regardless and also be aware of opportunity cost and how you treat this.
For timings, always draw out a chart to show workings, and be clear on the exact timings given to you. Anything paid up front will not need to be discounted.
Finally, ensure you understand the tax requirements and the tax depreciation you can use to offset against your incoming cash inflows. Don’t mix up accounting depreciation and tax depreciation.
In the example attached I run through three simple steps to get to an NPV. Use the Excel function to show formulas to see where the numbers are coming from. I use the NPV formula but you can also grab a discount chart.