Investment appraisal - discounted cash flow techniques

Time value of money

money received today is worth more than the same sum received in the future; it has time value
this could occue due to
1. potential for earning interest - To justify capital investment it has to earn at least a minimum
Amount of profit so that the return compensates the investor for amount invested and length of
Time before profits are made
time value of money Is that $1 at a future date is worth less than $1 now
2. Impact of inflation - Funds Received today will buy more than the same amount a year later
its prices have risen in the meantime ; Funds are subject to a loss of purchasing power
3. Risk - The earlier cashflows are due to be received the most certain they are in less chances that
the events will prevent payment earlier cash flows are more valuable

compounding
A sum invested today will earn interest. compounding calculates the future or terminal value of a
given sum invested today for a number of years.
To compound a sum the figure is increased by the amount of interest it would earn over the period .

FV = P ( 1+ r )^n F = future value after n periods

P = present or initial value

Discounting
As cash flows may arise at different points in time in a potential project to make a useful comparison
of different flows they must all be converted to a common point in time usually the present day

PV = F or F(1+r)^-n or use the annuity table given CFs are constant

(1+r)^n
assumptions used :
all cashflows occur at the start or end of a year
initial investments occur at T 0
other cash flows start one year after that T 1

Cost of Capital / rate of interest / discount rate / required return

rate a firm should use to take account of the time value of money
discounting annuities discounting perpetuities
an annuity is a constant CF for a no. of years. a perpetuity is an annual CF that occurs forever
the annuity factor AF is the sum of individual DF for the foreseeable future'
PV = annual cash flow x AF PV = cash flow
AF = (1-(1+r)^-n) or the table given in exam r
r 1/r is the perpetuity factor
* in the use of AF and perpetuities, both assume the PV of a growing perpetuity
the first CF will be occuring in one years time. PV = CF at T1
Annuity or perptuity will discount the cash flows to r-g
give the value one year before the first CF at T0
*1/(r-g) perpectuity factor with growth
advanced annuities and perpetuites
regular CF may start now at T0 rather than T1
calc PV by ignoring the payment at T0 when considering the number of CF then adding one to the AF
or PF
annuitites
year 0 1 2 3 4
CFs 600 600 600 600 600
PV 600 + 600 X 4 year 10% AF

PV = 600 + (600 x 3.17) = 2502 or PV = 4.17 x 600 = 2502

perpetuities

year 0 1 2 3 4…...
CFs 2000 2000 2000 2000 2000
PV 2000 2000 x 9% PF

PV = 2000 + ( 2000 X 1/0.09) or 2000 x ( 1+ 1/0.09) = 24222

Delayed annuities and Perpetuities

some regular CFs may start later than T1. These are dealt with by;
1. applying appropriate factor to the CFs as normal
2. discounting your answer back to T0
Annuities
year 0 1 2 3 4 5
CFs 200 200 200
PV 544.65
494.01

perpetuities
year 0 1 2 3 4 5…..
CFs 200 200 200
PV 4000
3628.12
NPV vs IRR
both NPV and IRR are investment appraisal techniques that discount cash flows and are superior to the
nasic techniques. However only NPV can be used to distinguish between two mutually exclusive projects

* Project A has a lower IRR and applying the IRR rule

would prefer B, however in absolute terms, A has the
higher NPV at the company's COC and should be
preferred.
*therefore NPV is the better techniques as it tells us the
absolute increase in shareholder wealth as a result of
accepting the project at the current COC. IRR simply
tells us how far the COC could increase before the
project was not worth accepting
Class notes

10% today end of 12 months

Y0 Y1 Y2 Y3
base 100000 100000 110000 121000
interest 0 10000 11000 12100
total 100000 110000 121000 133100
PV FV FV FV

110000 121000 133100

compounding formulaFV = PV (1 + r)^n
r - rate
n - number of years
discounting formula PV = FV / (1+r)^n
one cash flow

Discounting annuities
Example 01 r 8%
year 0 1 2 3 4 5
CFs 20000 20000 20000 20000 20000
PV 92457.59328

deferred annuity
example 02 r 0.08
year 0 1 2 3 4 5
CFs 20000 20000 20000
PVs 79267.48395 92457.5933
PV = FV / (1+r)^n
example 03 r 11%
year 0 1 2 3 4 5
CFs 25000
PV 60865.04607 92397.42544

example 04 r 10%
year 0 1 2 3 4 5
CFs 22000 22000 25000
PV 38181.8182 83397.31
98861.42211 31555.2216 15523.03308 51783.17

example 05 r 10%
year 0 1 2 3 4 5
CFs 10000 8000 8000 8000
PV 9090.909091 19894.81593 25358.92
18086.1963
15745.89637
42923.00176
PV 42923.00176 9090.909091 6611.57025 6010.51841 5464.107643 0

example 06 r 13%
year 0 1 2 3 4 5
CFs 1700 3000 1700 1700 1700 3000
PV 1700 2654.867257 7083.457794
2654.867257 4013.959416
3552.176475
4344.417322
-1128.479585
1331.539334
3992.171086

PV of total 16446.69189

1700 2654.867257 1331.34936 1178.18528 1042.641837 1628.28

16446.69189

annuity due

Example 07 r 8%
year 0 1 2 3 4 5
CF 20000 20000 20000 20000 20000 20000
PV 92457.59328
112457.5933

method 1
PV = ordinary annuity formula x ( 1 + r )
112457.5933 where n is te no. of CF years in this case is 7

method 2
PV = annuity CF x Annuity factor +1
20000 5.62287966
112457.5933

r 10%
year 0 1 2 3 4
CFs 10000 10000 10000 10000 10000
PV using method 1 41698.65446
PV using method 2 41698.65446

perpetuity
annuity without an end date
PV = cashflow x 1/r

ordinary pepetuity r 8%
year 0 1 2 3 4 5
5000 5000 5000 5000 5000
PV 62500

pertuity due r 8%
year 0 1 2 3 4 5
CF 5000 5000 5000
PV 53583.67627 62500

deferred perpetuity r 8%
year 0 1 2 3 4 5
CFs 5000 5000 5000 5000 5000 5000
PV method 1 67500
PV method 2 67500

Basis Concern Usage scenario

ROCE Profit Relative profit - %
Payback Cashflow Shortest Economy is
recovery dynamic/uns
period of the table
investment
Do not
discount
cashflows,
NPV Discounted doesn’t
Overall look at
cashflows cashflows are
considered and
they are

payback
Example 01

Years Investment Cashflow NCF

0 (15,000,000) (15,000,000)
1 2,000,000 (13,000,000)
2 3,000,000 (10,000,000)
3 4,000,000 (6,000,000) payback period
4 5,000,000 (1,000,000) 4 years 3 months
5 4,000,000 3,000,000 -3
6 3,000,000
7 4,000,000
8 5,000,000

example 02
discounted payback cost of capital 8%
Years 0 1 2 3 4 5
Investment (15,000,000)
Net cashflows 2,000,000 3,000,000 4,000,000 5,000,000 #######
8% 0.926 0.857 0.794 0.735 0.681
PV of cashflow (15,000,000) 1,851,852 2,572,016 3,175,329 3,675,149 #######
Cumulative NPV (15,000,000) (13,148,148) (10,576,132) (7,400,803) (3,725,653) #######

disocunted payback
5 years 6 months

Example 03 cost of capital 10%

Years 0 1 2 3 4 5
Investment (25,000)
Net cashflows 5,000 4,000 3,000 5,000 4,000
Discount at 10% 1.000 0.909 0.826 0.751 0.683 0.621
NPVs -25000 4545 3306 2254 3415 2484
cumulatve NCF -25000 -20455 -17149 -14895 -11480 -8996

discounted payback
8 years 11.6 months

Years 0 1 2 3 4 5
Investment (50,000) 18,000 25,000 20,000 10,000 5,000
15% 1 0.870 0.756 0.658 0.572 0.497
PV (50,000) 15,652 18,904 13,150 5,718 2,486
25% 1.000 0.800 0.640 0.512 0.410 0.328
PV -50000 14400 16000 10240 4096 1638

COC increases NPV reduces

IRR

IRR 21.20%
L 15%
H 25%

L 15%
NL (NPVL) 5,909.51 IRR 21.2%
H 25%
NH (NPVH) (3,625.60)
 Net Present Value (NPV)
Represents the surplus funds (after funding the investment) earned on the project by discounting
all the relevant cash flows associated with the project back to their PV.
if NPV > 0 then financially viable NPV gives the impact of the project on
If NPV = 0 project breaks even shareholder wealth.
If NPV < 0 then project is not financially viable

You should never include interest payments as cash flows within an NPV calculation as these are taken
account of by the cost of capital

Advantages
NPV is superior to all others
considers time value of money - impact of interest, inflation anf risk over time
absolute meaure of return - allows for more effective planning
based on cash flows and not profits - subjectivity of cash flows make them less reliable for decision
considers whole life of the project - considers all relevant cash flows
should lead to maximisation of shareholder wealth

disadvantages
1. difficult to explain to managers - to understand NPV calc and discounting not intuitive as payback
2. requires knowledge of the cost of capital - gathering data and making calc based on data and
estimates
3. relatively complex

Internal Rate of Return

IRR represents the discount rate at which the NPV of an investment is zero; breakeven cost of capital.
a project should be accepted if the IRR > Cost of capital.

to calculate the exact DCF rate of return that the project us expected to achieve.
if NPV > 0 it is earning more than the COC and vice versa
the % return on investment must be the rate of discount or COC at which NPV is 0 - IRR or the DCF yield
if its hgher than the target rate of return then project is financially viable.
IRR = L+ NL x (H - L ) L is the lower rate of interest NL - NPV at lower rate
NL - NH H is higher rate of interest NH - NPV at higher rate

IRR may be calculated by a linear interpolation by assuming a linear relationship between NPV
and discount
IRR with perpetuities
annual inflow x 100
initial investment
 Advantages
1. considers time value of money, the current value earned from an investment project = more accurate
2. IRR is a percentage and hence easily understood. This can be simply compared with the required
rate of return of the organisation
3. IRR uses cash flows and not profits, less subjective
4. considers the whole life of the project
5. means selecting projects where IRR exceeds the COC should increase shareholders wealth. This holds
true given that the project CF follow the standard pattern of an outfow by a series of inflows.

Disadvantages
1. it is not a measure of absolute profitability
2. interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet
programme, the COC itself is only an estimate and if the margin between required return and IRR is
small then this lack of accuracy could actually mean the wrong decision is taken
3. It is fairly complicated to calculate. Note that where small margins exists, the projects success
would be considered to be sensitive to the discount rate
4. non conventional cash flows may give rise to multiple IRRs which means the interpolation method
cant be used. Even where the project has one IRR it can be seen from the graph that the decision
rule would lead to the wrong result as the project does not earn a positive NPV at any COC
5. Contains an inherent assumption that cash returned from the project will be re-invested at the
porjects IRR, which may be unrealistic. The assumption is that the cash inflows generated by the
project will be reinvested at an equally beneficial level of return as this project; whereas cash is more
likely to be invested un projects at that return or above.

ying the IRR rule it is possible for a project to have upto as many
terms, A has the IRRs as there are sign changes in the cashflows
NPV profile could take various forms depending
on the relative magnitude of the CFs
ues as it tells us the IRR and Cost of initial investment are
alth as a result of independent of the risk of the project
COC. IRR simply
ase before the
TYU 1
6700.478203

TYU 2
68068.32331

TYU 3

year 0 1 2 3 4
CFs -25000.0 6000.0 10000.0 8000.0 7000.0
6% 1.0 0.9 0.9 0.8 0.8
PV -25000.0 5660.4 8900.0 6717.0 5544.7
NPV 1822.0

TYU 4

year 0 1 2 3 4 5
CFs -240000 80000 120000 70000 40000 20000
9% 1.000 0.917 0.842 0.772 0.708 0.650
PV -240000 73360 101040 54040 28320 13000
NPV 29760

TYU 9
14.17%

6
20000

6 7 8
20000 20000 20000
 6 7 8 9
25000 25000 25000 25000

6 7 8 9 10
22000 22000 22000 22000 22000

6 7 8 9
8000 8000 8000 8000

4515.79144 4105.2649 3732.059 3392.78095

6 7 8 9 10 11 12
3000 3000 -3000 4000 3000 3000 3000
11992.6494

1440.955582 1275.1819 -1128.4796 1331.53933 883.765044 782.0929596 692.1176634

6
20000
…infinity
5000

…infinity
5000

…infinity
5000
 6 7 8

3,000,000 4,000,000 5,000,000

0.630 0.583 0.540
1,890,509 2,333,962 2,701,344
887,188 3,221,150

6 7 8 9 10 11

3,000 5,000 4,000 7,000 7,000 7,000

0.564 0.513 0.467 0.424 0.386 0.350
1693 2566 1866 2969 2699 2453
-7303 -4737 -2871 98 2797 5250

5,910

-3626
 13 14 15
3000 3000 3000

612.4935074 542.0297 479.6723