Discounted Cash Flow

Analysis

Dr Nurin Haniah Asmuni

Centre for Actuarial Studies
Faculty of Computer and Mathematical
Sciences
Universiti Teknologi MARA
29 March 2016
Outline
 Introduction
 Discounted Cash Flow (DCF)
Techniques
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)

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Introduction
 Capital Budgeting is the process of determining which
real investment projects should be accepted and
given an allocation of funds from the firm.
 To evaluate capital budgeting processes, their
consistency with the goal of shareholder wealth
maximization is of utmost importance.

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Discounted Cash Flow (DCF)
Techniques
 The main DCF techniques for capital budgeting
include: Net Present Value (NPV), Internal Rate of
Return (IRR), and Profitability Index (PI)
 Each requires estimates of expected cash flows (and
their timing) for the project.
 Including cash outflows (costs) and inflows (revenues or
savings) – normally tax effects are also considered.
 Each requires an estimate of the project’s risk so that
an appropriate discount rate (opportunity cost of
capital) can be determined.
 The discussion of risk will be deferred until later. For
now, we will assume we know the relevant opportunity
cost of capital or discount rate.
 Sometimes the above data is difficult to obtain –
this is the main weakness of all DCF techniques.
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Net Present Value (NPV)
 Method: NPV = PVinflows – PVoutflows
 If NPV ≥ 0, then accept the project;
otherwise reject the project.

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Net Present Value (NPV)
The NPV of a series of cash flows is the PV of cash
inflows minus the PV of the cash outflows:
n n
cash inflow t cash outflowt
NPV   
t 0 1  r t
t 0 1  r t

Expressed another way, NPV is the sum of the PV

of all net cash flows over n years
n
net CFt
NPV  
t 0 1  r t

where net CFt  cash inflow t  cash outflowt

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 Net Present Value
(NPV)

NPV is the present value of an

investment project’s net cash
flows minus the project’s initial
cash outflow (ICO).

CF1 CF2 CFn

NPV = (1+k)1 + (1+k)2+ . . + (1+k)n - ICO

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 Proposed Project Data

Julie Miller is evaluating a new project for

her firm, Basket Wonders (BW). She has
determined that the after-tax cash flows
for the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000,
respectively, for each of the Years 1
through 5. The initial cash outlay will be
$40,000.

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 NPV Solution

Basket Wonders has determined that the

appropriate discount rate (k) for this
project is 13%.
10,000 12,000 15,000
NPV = + + +
(1.13)1 (1.13)2 (1.13)3

10,000 7,000
+ - 40,000
(1.13)4 (1.13)5

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NPV Solution
NPV = - 40,000 + 10,000(1.13−1 ) +
12,000(1.13−2 ) + 15,000(1.13−3 ) +
10,000(1.13−4 ) + 7,000(1.13−5 )

NPV = - 40,000 + 10,000(.885) + 12,000(.783) +

15,000(.693) + 10,000(.613) + 7,000(.543)

NPV = - 40,000 + 8,850 + 9,396 + 10,395 + 6,130

+ 3,801
= - 1,428
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 NPV Acceptance Criterion

The management of Basket Wonders

has determined that the required rate
is 13% for projects of this type.

Should this project be accepted?

No! The NPV is negative. This means that

the project is reducing shareholder wealth.
[Reject as NPV < 0 ]
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Internal Rate of Return (IRR)
 IRR is the rate of return that a project generates.
Algebraically, IRR can be determined by setting up an
NPV equation and solving for a discount rate that
makes the NPV = 0.
 Equivalently, IRR is solved by determining the rate
that equates the PV of cash inflows to the PV of cash
outflows.
 Method: Use your financial calculator or a
spreadsheet; IRR usually cannot be solved manually.
 If IRR ≥ opportunity cost of capital (or hurdle rate),
then accept the project; otherwise reject it.

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Internal Rate of Return (IRR)
 IRR is the interest rate that equates the PV of
cash inflows with the PV of the cash outflows:
n n
cash inflowt cash outflowt

t 0 1  IRR 
t

t 0 1  IRR t

 In other words the IRR is the interest rate that

causes the NPV to equal to zero:
n
net CFt
NPV   0
t 0 1  IRR 
t

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Independent Project
 For this project, assume that it is independent of any other
potential projects that Basket Wonders may undertake.

 Independent -- A project whose acceptance (or rejection)

does not prevent the acceptance of other projects under
consideration.

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 Internal Rate of Return
(IRR)

IRR is the discount rate that equates the

present value of the future net cash flows
from an investment project with the
project’s initial cash outflow.

CF1 CF2 CFn

ICO = (1+IRR)1 + (1+IRR)2 + . .+
(1+IRR)n

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 IRR Solution

40,000= 10,000 12,000

+ +
(1+IRR)1 (1+IRR)2
15,000 10,000 7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal 40,000.

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 IRR Solution (Try 10%)

40,000 = 10,000(1.10−1 ) + 12,000(1.10−2 )

+15,000(1.10−3 ) + 10,000(1.10−4 ) +
7,000(1.10−5 )

40,000 = 10,000(.909) + 12,000(.826) +15,000(.751)

+ 10,000(.683) + 7,000(.621)

40,000 = 9,090 + 9,912 + 11,265 + 6,830 + 4,347

= 41,444 [Rate is too low!!]

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 IRR Solution (Try 15%)

40,000 = 10,000(1.15−1 ) + 12,000(1.15−2 ) +

15,000(1.15−3 ) + 10,000(1.15−4 ) +
7,000(1.15−5 )
40,000 = 10,000(.870) + 12,000(.756) +
15,000(.658) + 10,000(.572) +
7,000(.497)
40,000 = 8,700 + 9,072 + 9,870 +
5,720 + 3,479
= 36,841 [Rate is too high!!]

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 IRR Solution (Interpolate)

.10 41,444
X 1,444
.05 IRR 40,000 4,603
.15 36,841

X 1,444
=
.05 4,603

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 IRR Solution (Interpolate)

.10 41,444
X 1,444
.05 IRR 40,000 4,603
.15 36,841

X 1,444
=
.05 4,603

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 IRR Solution (Interpolate)

.10 41,444
.05 X IRR 40,000 1,444 4,603
.15 36,841

X = (1,444)(0.05) X = .0157
4,603
IRR = .10 + .0157 = .1157 or 11.57%
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 IRR Acceptance Criterion

The management of Basket Wonders has

determined that the hurdle rate is 13% for
projects of this type.

Should this project be accepted?

No! The firm will receive 11.57% for each

dollar invested in this project at a cost of
13%. [ IRR < Hurdle Rate ]

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Profitability Index (PI)
 Method: PVCash flows after the initial investment
PI 
Initial Investment
 Note: PI should always be expressed as a
positive number.
 If PI ≥ 1, then accept the real investment
project; otherwise, reject it.

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 Profitability Index (PI)

PI is the ratio of the present value of a

project’s future net cash flows to the
project’s initial cash outflow.
Method #1:

CF1 CF2 CFn

PI = + +...+ ICO
(1+k) (1+k)
1 2 (1+k)n

<< OR >>
Method #2:
PI = 1 + [ NPV / ICO ]
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 PI Acceptance Criterion

PI = $38,572 / $40,000
= .9643 (Method #1)

Should this project be accepted?

No! The PI is less than 1.00. This

means that the project is not profitable.
[Reject as PI < 1.00 ]
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