Advanced Financial

Management

ACCA P4

Session 1
 Contents

Discounted CashFlow Techniques

Net Present Value

Capital Allowance

Inflation

Internal rate of Return

Discounted Payback Period

Comprehensive example

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 Advanced Investment Appraisal
Discounted Cash Flow Techniques

Discounting cash flow techniques are investment appraisal techniques which take
into account both the time value of money and also total profitability over the project
Meaning
life. It is therefore superior to both the ARR and the payback as methods of
investment appraisal.
The discounting methods include:
• Net Present Value (NPV)
• Internal rate of return (IRR)
• Modified Internal rate of return (MIRR)
Inclusions • Discounted payback period
• Duration
• Profitability Index (PI)
• Adjusted Present Value

Main objective – Maximizing Shareholder’s Wealth

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 Advanced Investment Appraisal
Net Present Value

• The NPV of a project is the value obtained by discounting all the cash outflows and inflows at a
chosen target rate of return or cost of capital and taking the net total. That is the present value of
inflows minus present value of outflows.

• Formula = PV of cash inflows – PV of cash outflows

• Variables required for calculating NPV:

• Number of years
• Relevant cash flows
• Appropriate discount factor

If NPV > 0, accept the proposal

If NPV < 0, reject the proposal

If NPV = 0, indifferent

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 Advanced Investment Appraisal
Net Present Value

• A relevant cash flow is a future cash arising as a result of a decision.

• The cash flows that should be included are those specifically generated or
incurred as a result of the accepting or non-accepting of the project.
Relevant cash
• Relevant cash flows should be judged on the basis of :
flows • Incremental cash flows
• Avoidable cash flows
• Opportunity cost
Irrelevant cash flows include:
• Depreciation: It is not a cash flow item. If profit is given after depreciation, the
depreciation should be added back to get the cash flows.
Irrelevant cash • Apportioned fixed cost – Fixed cost may appear in a DCF calculation only if it is
flows know that they will increase as a result of accepting a project.
• Interest Payment – This is factored into the discount rate.
• Sunk or Past costs

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 Advanced Investment Appraisal
Net Present Value

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 Advanced Investment Appraisal
Net Present Value

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 Advanced Investment Appraisal
Inflation

Money cash • These are the predictions of actual sum of money which will be received and
paid taking into account the predicted inflation levels.
flow/ Nominal
cash flow • Nominal = Already inflated
These are cash flows expressed in today’s prices. In other word these cash flows
Real cash flow are not inflated.

If Cash Flow (Nominal) , Discount Factor (Nominal)

Remember!! If Cash Flow (Real) , Discount Factor (Real)

Formula
(1+m) = (1+r) x (1+i)
m = money/ nominal rate
r = real rate
i = inflation rate

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 Advanced Investment Appraisal
Inflation
Example 1
A Company has a real rate of interest of 5% and the expected inflation is 3%, what is the nominal return ??

Example 2
A project require an outlay of $1.5m in year 0 and will repay cash flows in real terms (today`s prices) as follows:

Year $000
1 670
2 500
3 1,200

The Company’s money cost of capital is 15.5%

Appraise the project if inflation is estimated to remain at 5% per annum.

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 Advanced Investment Appraisal
Capital Allowance

• The Capital allowances are used to reduce the taxable profits and the consequence reduction in a
tax payment should be treated as a cash savings arising from the acceptance of a project.

• Cash savings on capital allowance = Capital Allowance x Tax Rate

 Example :-

Initial Investment = 2,000

Capital Allowance = 25% reducing balance
Useful Life = 4 years
Tax Rate = 30% (Payable in same year)
Scrap Value = 500

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 Advanced Investment Appraisal
Internal Rate of return

• IRR is that discount rate which gives a net present value of zero. Alternatively,
Meaning the IRR can be described as the maximum cost of capital that can be applied to
finance a project without causing harm to the shareholders.
IRR = L% + NPV (L) x (H% - L%)
NPV (L) – NPV (H)
Where,
Formula
L% = Lower discount rate
H% = Higher discount rate
NPV (L) = NPV at lower discount rate
NPV (H) = NPV at higher discount rate
If IRR > Cost of capital, accept the proposal
Decision rule

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 Advanced Investment Appraisal
Internal Rate of Return

Where there is conflict between IRR and NPV, accept the project with the larger NPV

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 Advanced Investment Appraisal
Internal Rate of Return

Example

A company is considering the purchase of a piece of equipment costing $120,000 that would save
$30,000 each year for five years. The equipment could be sold at the if its useful life for $15,000. The
company requires every project to yield a return of 10% or more otherwise they will be rejected.

Should this equipment be purchased ?

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 Advanced Investment Appraisal
Payback Period

• The time period, in which the initial investment is recovered.

Meaning • In other words the number of years for the cash out lay to be matched by cash
inflows.
Initial Investment
Formula Annual Inflows

If Payback period < target payback period, accept the proposal

If Payback period > target payback period, reject the proposal
Decision rule

Project with minimum payback period should be preferred

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 Advanced Investment Appraisal
Payback Period

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 Advanced Investment Appraisal
Discounted Payback Period

• The time period in which initial investment is recovered in terms of present value is known as
discounted payback period.

• It is same as simple payback period. The only difference is that the discounted cash flows are
used instead of simple cash flows for calculation.

If discounted payback period < target payback period, accept the proposal

If discounted payback period > target payback period, reject the proposal

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 Advanced Investment Appraisal
Discounted Payback Period
Example
Year Cash Flows PVF(10%)
0 (500,000) 1.000
1 300,000 0.909
2 200,000 0.826
3 200,000 0.751
4 600,000 0.683

Compute the discounted payback period.

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 Advanced Investment Appraisal
Comprehensive Example
ABC Co is considering a project – whether or not to commercialise an innovative muscle toning device (MTD) that
will be used in the treatment of sporting injuries. It is expected that the commercial life of MTD will be four years
after which technological advances will bring more sophisticated devices to the market and the sales of MTD will
fall to virtually zero. $8,000,000 has been spent in developing and testing the device over the past year. Initial
market research has been conducted at a cost of $2,500,000 and is due to be paid shortly.

Information on future returns from the investment has been forecast to be as follows:

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 Advanced Investment Appraisal
Comprehensive Example
Selling price inflation and fixed costs inflation are expected to be 5% per year and variable cost inflation is expected
to be 4% per year. Fixed costs represent incremental fixed production overheads which are wholly attributable to
the project. The production equipment for the new device would cost $120 million and an additional initial
investment of $20 million would be needed for working capital. The equipment is expected to be sold at the end of
four years for $10 million when the production and sales cease. The average general level of inflation is expected
to be 3% per year and working capital would experience inflation of this level.

Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis could be claimed on the cost of
equipment. Profit tax of 30% per year will be payable one year in arrears. A balancing allowance would be claimed
in the fourth year of operation. ABC Co has a real cost of capital of 7.8%.

Required: calculate the NPV / IRR / Discounted payback.

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 Thank you

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