Discounted Cash Flow (DCF) Methods

Discounted cash flow methods use cash flows and automatically make allowance for time value of money. As
previously mentioned, accounting profits are based on conventions and are less objective than cash flows so
that cash flows are preferred for decision making.
There is general acceptance that any serious investment appraisal must consider the time value of money.
Some monies arising at different times are not directly comparable. They must be converted to equivalent
values at some common date, using a discounting factor. As investments are essentially outlays of funds in
anticipation of future returns, the presence of time as a factor in investment is fundamental rather than
incidental. Time is always crucial for the investor so that a sum received today is worth more than the same
sum to be received tomorrow. Thus, in evaluating investment projects, it is important to consider the timing
of returns on investments. In a way, time is the dimension through which the monetary variables involved in
investments - the capital outlays and subsequent receipts - must be related.
Discounted cash flow technique considers the net cash flow as representing the recovery of original
investments, plus a return on capital invested.
There are three main DCF methods viz: Net Present Value (NPV) Profitability Index (PI) and Internal Rate of
Return (IRR), however, only the NPV is treated in this study guide as other methods are outside the coverage
of the syllabus at this level.

Net Present Value (NPV) Method

This method generally establishes a 'target' - a minimum rate below which a proposal would be rejected by
management as undesirable in the light of the profit goals and above which it would be considered
favourable. It seeks to determine whether present value of estimated future cash inflows at management's
desired rate of return will be greater or less than the cost of the proposal. Thus, cash inflow, initial
investment and desired rate of return are given in this method while the present value of cash inflows and its
deviation from initial investment are to be determined.
The profitability of a project is ascertained by comparing the amount which meets the stated condition (i.e.
pre-determined minimum rate, with the actual amount of investment required by the contemplated project).
If a project's earnings could return with interest at the market rate an amount greater than that actually
required for investment in the project, the project is adjudged profitable.
The NPV method involves calculating the present values of expected cash inflows and outflows through the
process of discounting, and establishing whether in total the present value of cash inflows is higher than the
present value of cash outflows.
The decision rule is to accept a project which has a positive NPV
PRACTICE QUESTIONS
QUESTION 1
Alhaji Aminu Tijjani is considering buying a machine which will improve his cash flows byN60,000 per annum
for the next five years, at the end of which the machine will be worn out and be of no value. The machine
which will cost N150,000 and be bought for cash has an estimated working capital of N10,000. Assume that
the cost of the capital to the company is 15%.
You are required to calculate the Net Present Value of this project and advice Alhaji Aminu Tijjani.
QUESTION 2
Garko Industries is considering an investment in a fleet of ten delivery vans to take its products to customers.
The vanswill costN30, 000 each to buy, payable immediately. The annual running costs are expected to total
N40, 000 for each van (including the driver's salary). The vans are expected to operate successfully for 6
years, at the end of which they will all have to be scrapped with disposal proceeds expected to be about N6,
000 per van. At present, the business uses a commercial carrier for all of its deliveries. It is expected that this
carrier will charge a total of N460, 000 each year for the next 6 years to undertake the deliveries.
Calculate the NPV of the project. Use 15% discount rate
QUESTION 3
A company wishes to expand its production. Two proposals of capital expenditure are being considered, each
of the two proposals requires more or less the same outlay. You, as the management accountant of the
Company, are required to furnish profitability estimate to guide the Board in its decision. Describe briefly two
methods that can be used for this purpose.

QUESTION 4
Give a comparative description of the Pay Back Period and Net Present Value approaches of investment
appraisal. Which one of the two do you consider superior?

QUESTION 5
(a)Describe briefly the Pay Back Period method of investment appraisal techniques and state five
advantages and five disadvantages of the method .
(b)Using the information given below, prepare tables showing the Net Present Values of each of the projects
based on applicable rates of12% and 15%per annum respectively:
Project X Project X

Year N N

Initial Investment 0 100,000 100.000

Cash flows 1 5,000 60,000

2 20,000 40,000
3 100,000 100,000
4 10,000 5,000

Briefly compare the two projects and comment on which of the two projects would be
profitable and should be undertaken.
QUESTION 6
Modern Tech. Services Ltd is considering two alternative projects for a business expansion
programme in the Northern part of the country. The projects have the following Naira
cashflowprofiles according to the data supplied by the company'sAccountant:
YEARS Project 1 Project 2
N N
0 -1,000,000 -3,000,000
1 -2,000,000 200,000
2 950,000 500,000
3 850,000 650,000
4 780,000 750,000
5 620,000 800,000
6 400,000 1,900,000
7 100,000 200,000

Required:
(a) Calculate the payback period for each project.
(b) Based on payback periods, advicewhich of the two projects should be chosen.
(c) State the advantages and disadvantages of the payback period criterion of investment
appraisal.