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Applying simulation to investment decisions 199
future sums of money is very straightforward. It simply involves multiplying
the sum of money by a present value factor, which can be obtained
from published tables.
Let us now use a simple example to illustrate the net present value
approach to investment appraisal. A company has to choose between
two new machines, the Alpha and the Beta. Both machines would
cost $30 000 and have an expected lifetime of 4 years. Estimates of the
annual cash inflows which each machine would generate are given
below together with estimates of the cash outflows which would be
experienced for each year of the machine’s operation. For simplicity, we
will assume that all the cash flows occur at the year end.
Alpha machine
Time of cash flow Year 1 Year 2 Year 3 Year 4
Cash inflows $14 000 $15 000 $15 000 $14 000
Cash outflows $2 000 $4 000 $6 000 $7 000
Beta machine
Time of cash flow Year 1 Year 2 Year 3 Year 4
Cash inflows $8 000 $13 000 $15 000 $21 500
Cash outflows $4 000 $4 000 $5 000 $5 000
Table 7.5 shows the calculations which are involved in determining
the net present value of the two potential investments. First, the net
cash flow is determined for each year. These net cash flows are then
discounted by multiplying by the appropriate present value factor. (The
present value factors used in Table 7.5 are based on the assumption that
a 10% discount rate is appropriate.) Finally, these discounted cash flows
are summed to give the net present value of the project. It can be seen
that, according to the NPV criterion, the Alpha machine offers the most
attractive investment opportunity.
While this approach to investment appraisal is widely used, the
NPV figures are obviously only as good as the estimates on which the
calculations are based. In general, there will be uncertainty about the size
of the future cash flows and about the lifetime of the project. Expressing
the cash flow estimates as single figures creates an illusion of accuracy,
but it also means that we have no idea as to how reliable the resulting
NPV is. For example, it may be that the year 1 cash inflow for the Beta
machine could be anything from $2000 to $14 000, and we have simply
used the mid-range figure, $8000, as our estimate. If the actual flow did