Cash Flows: NPV and IRR

Although NPV and IRR are often used alongside business cases to evaluate whether or not to
undertake new capital investments, the Study Guide also specifically mentions them as measures
of performance.

In this context, they can be useful as controls by comparing actual results to those planned.
Moreover, they are useful because they focus on future cash flows and make allowance for risk
(through the use of discount factors).

The advantages and weaknesses of NPV compared with ROI and RI

Advantages include:
i. Cash flows are less subject to manipulation and subjective decisions than accounting
profits.
ii. It considers the opportunity cost of not holding money.
iii. Risk can be allowed for by adjusting the cost of capital.
iv. Shareholders are interested in cash flows (both in the short term and long term).

The disadvantages of the NPV approach are centred on the assumptions underlying the values of
critical variables within the model. For example:
(a) The duration of the cash flows
(b) The timing of the cash flows
(c) The appropriate cost of capital

Cash flows and NPVs for strategic control: shareholder wealth

Control and performance measures at a strategic level do need to pay some attention to wealth.
Shareholders are interested in cash flow as the safest indicator of business success.

According to one model of share valuations, the market value of the shares is based on the expected
future dividend.

Control at a strategic level should be based on measurements of cash flows (actual cash flows
for the period just ended and revised forecasts of future cash flows). Since the objective of a
company might be to maximise the wealth of its shareholders a control technique based on the
measurement of cash flows and their NPV could be a very useful technique to apply.

A numerical example might help to illustrate this point.

Now suppose that ABC Co reviews its position 1 year later.
a) It can measure its actual total cash flow in 20X1: roughly speaking, this will be the funds
generated from operations minus tax paid and minus expenditure on non-current assets
and plus/minus changes in working capital.
b) It can revise its forecast for the next few years.

We will assume that there has been no change in the cost of capital. Control information at the
end of 20X1 might be as follows.

A control summary comparing the situation at the start of 20X1 and the situation 1 year later
would now be as follows.

 You might wonder why we are doing this.

of 1/(1.15)N, where N
= number of years between 20X1 and the cash flow.

If we were to calculate the NPV starting at a point a year later the discount factor for each
of the cash flows would be 1/(1.15)N-1 (ie a cash flow at year 2 (31 December 20X2) from
1 January 20X1 would have a discount factor of 1/1.152, but when NPV is recalculated at
31 December 20X1 discount factor for 31 December 20X2 cash flow = 1/1.15. So each
discount factor for recalculating is multiplied by 1.15 (changing 1/1.15N to 1/1.15N-1).
 We can therefore ; multiply total NPV at 1 January 20X1 by 1.15 to get what NPV should
have been at 31 December 20X1.

** The uplifting shows by how much the expected NPV would change if we were doing
the calculation 12 months later.

The control information shows that by the end of 20X1, ABC Co shows signs of not achieving
the strategic targets it set itself at the start of 20X1.

This is partly because actual cash flows in 20X1 fell short of target by (200-180) $20,000, but
also because the revised forecast for the future is not as good now either. In total, the company
has a lower NPV by $47,000.

The reasons for the failure to achieve target should be investigated. Here are some possibilities:
i. A higher-than-expected pay award to employees, which will have repercussions for
the future as well as in 20X1
ii. An increase in the rate of tax on profits
iii. A serious delay in the implementation of some major new projects
iv. The slower-than-expected growth of an important new market

Strategic progress can therefore be measured by reconciling successive net present values and
the intervening cash flows.

Internal Rate Of Return (IRR)

IRR is another way of reviewing investments. The IRR of a project can be compared to the cost
of capital.
A project’s internal rate of return (IRR) is the required rate of return (or cost of capital) which
leads to the project having a net present value of zero when that rate of return is used to discount
the project’s cash flows.

An organisation should undertake a project if the IRR of that project is greater than the
organisation’s cost of capital.

Modified Internal Rate Of Return (MIRR)

- One of the weaknesses of IRR is that it assumes that cash flows after the investment
phase are reinvested at the project’s IRR over the life of the project (the reinvestment
assumption).
 - However, a better assumption is that funds will be reinvested at the investor’s required
return (or cost of capital).

- The problem of the reinvestment assumption can be addressed by using the modified
internal rate of return (MIRR). The MIRR distinguishes between the investment phase
of a project and the return phase, and is calculated as follows:

Consider a project requiring an initial investment of $24,500, with cash inflows of

$15,000 in years 1 and 2 and cash inflows of $3,000 in years 3 and 4. The cost of capital
is 10%.

MIRR can be computed by calculating the present value of the investment phase and the return
phase. Note that the MIRR is calculated on the basis of investing the inflows at the cost of
capital.
 PVR = Total PV for years 1 – 4(the return phase) = $30,327
PVI = Cost of investment (the investment phase) = $24,500
MIRR = [30,327/24,500] ¼ × (1 + 0.1) – 1 = 16%

The MIRR of 16% is likely to be a better measure than the IRR of 24.7%. The MIRR is
invariably lower than the IRR.

NB: when preparing an MIRR calculation it is vital to distinguish the cash flows from a project
into the return and the investment phases. The initial cash outflows at the start of a project
represent the ‘investment' phases, and then subsequent cash inflows represent the ‘return' phase.

IRR method has a number of disadvantages.

1. It ignores the relative size of investments.
2. There are problems with its use when a project has non-conventional cash flows or when
deciding between mutually exclusive projects.
3. Discount rates which differ over the life of a project cannot be incorporated into IRR
calculations.

ECONOMIC VALUE ADDED (EVA)

- EVA ® is an alternative absolute performance measure. It is similar to RI because both
are calculated by subtracting an imputed interest charge from the profit earned by a
company or division.

The key differences between EVA and RI are:

i. The profit figures are calculated differently. EVA is based on an 'economic profit'
which is derived by making a series of adjustments to the accounting profit.
 ii. The notional capital charges use different bases for net assets. The replacement cost
of net assets is usually used in the calculation of EVA.

Economic value added (EVA) is a specific performance measure, developed and registered as a
trade mark by the Stern Stewart consulting organisation. EVA is an extension of the traditional
income method, but it incorporates adjustments to adjust perceived distortions introduced by
generally accepted accounting principles.

The logic behind EVA is that if the primary objective of commercial organisations is to
maximise the wealth of their shareholders, then performance measures should evaluate how
well they are doing this.
Profit-based measures, which many organisations use as their primary measure of financial
performance, do not do this because:
a) Profit ignores the cost of equity capital. Financial statements take account the cost of debt
finance when calculating profit, but ignore the cost of equity finance.
b) Profits calculated in accordance with accounting standards do not truly reflect the wealth
that has been created.

The way EVA is calculated takes account of these concerns:

EVA = net operating profit after tax (NOPAT) less capital charge
(where the capital charge = weighted average cost of capital (WACC) x net assets)

Although the logic behind EVA is similar to that of RI (in other words, subtracting an imputed
interest charge from the profit earned by a company or division) the calculation of EVA is
different to RI because the net assets used as the basis of the imputed interest charge are usually
valued at their replacement cost and are increased by any costs that have been capitalized.

There are also differences in the way that NOPAT is calculated, compared with the profit
figure that is used for RI. There are three main reasons for adjusting accounting profits to derive
NOPAT:
i. Costs which would normally be treated as expenses in the financial statements, but
which are considered within an EVA calculation as investments building for the
future, are added back to derive a figure for 'economic profit'. These costs are
included instead as assets in the figure for net assets employed; in other words, they
are deemed to be investments for the future. Costs treated in this way include items
such as research and development expenditure, and advertising costs.
ii. Cash accounting versus accruals. Investors are primarily interested in cash flows,
so accounting adjustments for non-cash items, such as allowances for doubtful debts,
are eliminated.
 iii. Investors, who are interested in maximising their wealth, will be interested in the
continuing performance of the company. Therefore one-off, unusual items of profit
or expenditure should be ignored.

Table 1: Accounting adjustments in EVA

Type of Item comment

Value-building expenditure Expenditure on marketing and promotions, research and
development, and staff training which will generate value for
the business in future periods should be capitalised. If any such
expenditure has been charged as an expense in the income
statement, it should be added back to profit, and also added to
capital employed in the year in which the expenses were
incurred.
Value-building expenditure The charge for depreciation in the income statement should be
added back to profit, and a charge for economic depreciation
made instead.
The value of non-current assets (and therefore capital employed)
should also be adjusted to reflect the revised charge.
Economic depreciation reflects the true change in value of assets
during the period.
Provisions Provisions, allowances for doubtful debts, inventory write-
downs, and
deferred tax provisions are deemed to represent over-prudence
on the part of financial accountant, and lead to the true value of
capital
employed being understated. Therefore they should all be added
back to capital employed.

Any movements in provisions recognised as income or expenses

in the income statement also need to be removed from NOPAT.
Non-cash expenses All non-cash items (eg goodwill) are treated with suspicion, on
the basis that if the costs were ‘real’, cash would have been paid
for them.
Any non-cash expenses should be added back to profits, and to
capital employed.
Operating leases Operating leases should be capitalised and added to capital
employed.

Otherwise, the inconsistency in treatment between operating and

 finance leases mean that firms can take advantage of operating
leases to reduce the capital employed figure, and in doing so
increase EVA.
In effect, EVA treats all leases as finance leases.

Any operating lease charges in the income statement should be

added back and removed from NOPAT.

Example: calculating EVA

A company has reported operating profits of $21 million. This was after charging $4 million for
the development and launch costs of a new product that is expected to generate profits for four
years.Taxation is paid at the rate of 25% of the operating profit.

The company has a risk adjusted weighted average cost of capital of 12% per annum and is
paying interest at 9% per annum on a substantial long term loan.

The company's non-current asset value is $50 million and the net current assets have a value of
$22 million. The replacement cost of the non-current assets is estimated to be $64 million.
Required
Calculate the company's EVA for the period.
Using EVA as a performance measure
EVA (like RI) gives an absolute measure, rather than a percentage value of performance, and if
EVA is positive it indicates an organisation is generating a return greater than that required by
the providers of finance. In other words, a positive EVA indicates that an organisation is creating
wealth for the shareholders.

Consequently, directors should be encouraged to either:

a) Invest in divisions where the returns from those divisions exceed the cost of capital.
b) Close down divisions, or harvest assets, where the return is less than the cost of capital.
In turn, the proceeds from any sales can either be re-invested in other divisions, or
returned to shareholders as dividends

Evaluation of EVA
The advantages of EVA include the following.
a) Real wealth for shareholders. Maximisation of EVA will create real wealth for the
shareholders. Maximising the present value of future cash flows will help maximise
shareholders’ wealth.
 b) Less distortion by accounting policies. The adjustments within the calculation of EVA
mean that the measure is based on figures that are closer to cash flows than accounting
profits.
c) Consistent with net present value (NPV). EVA is consistent with the idea of net present
value, showing the return on projects in excess of the cost of financing them. Any
projects which would generate a positive NPV will also increase EVA.
d) An absolute value. The EVA measure is an absolute value, which is easily understood
by nonfinancial managers.
e) Treatment of certain costs as investments thereby encouraging expenditure. If
management are assessed using performance measures based on traditional accounting
policies they may be unwilling to invest in areas such as advertising and development for
the future because such costs will immediately reduce the current year's accounting
profit. EVA recognises such costs as investments for the future and thus they do not
immediately reduce the EVA in the year of expenditure. This will reduce the temptation
(which may occur under ROCE or ROI) to shorttermism.

EVA does have some drawbacks.

a) Dependency on historical data. EVA is based on historical accounts, which may be of
limited use as a guide to the future. In practice, the influences of accounting policies on
the starting profit figure may not be completely negated by the adjustments made to it in
the EVA model.
b) Number of adjustments needed to measure EVA. Making the necessary adjustments
can be problematic as sometimes a large number of adjustments are required.
c) Comparison of like with like. EVA is an absolute measure, so larger companies in size,
may have larger EVA figures than smaller companies, simply because they are bigger,
not because they are performing better. Allowance for relative size must be made when
comparing the relative performance of companies. In this respect, return on investment
(which shows a percentage measure) may be better for comparing performance between
companies of different size.
d) Difficulty in estimating WACC. Many organisation use models such as the CAPM for
estimating
WACC. However, this is not a universally accepted method of determining the cost of
equity.