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Planning Investments - Discounted Cash Flow Techniques
Planning Investments - Discounted Cash Flow Techniques
Planning
investments –
discounted cash flow
techniques
Concept Map
CAPITAL
BUDGETING
ACCEPT REJECT
Learning Outcomes
• Define and identify investments.
• Identify cash flows associated with specific
investments.
• Use discounted cash flow to reduce these cash
flows to a common, present value basis.
• Calculate internal rate of return (IRR).
• Use NPV and IRR to compare investment
Introduction
This is one of the most important chapter of
the course. Review chapter 3, “The time
value of money”, before you start. Make sure
you understand each stage of this chapter
before you go on to the next.
How do you decide which of these three projects is the best for
the company?
Four common characteristics of investment decisions
1. Relatively large initial outlay – buying a new computer is
an investment decision; buying an ink cartridge is an
operating decision. (Sometimes, operating decisions can be
larger than investment decisions, but this is unusual!
2. Relatively long horizons – You expect a computer printer to
last for three years, an ink cartridge for three months.
3. Relatively difficulty to reverse – If you choose the wrong
computer printer, you won’t have the opportunity to
change it.
4. Projects have risk – If you spend money now in the
anticipation of future benefits, there is risk. Markets could
collapse due to fashion change; competitors could appear
unexpectedly; there could be disastrous political changes.
Investment and firm value
A good investment should increase firm value immediately. If
the Board announces that an investment has been made,
which will produce a guaranteed income with a net value of
$200,000, then this should immediately increase the value of
the company by $200,000. If there are 10 million shares, the
share price should jump by 2 cents immediately.
The direct overheads are extra costs incurred directly because of this extra
worker and his machine.
These might include
oiling the machine,
insurance on the worker,
Extra electricity used, and
Tea bags and toilet paper for the worker.
These you have met in studying marginal cost in FACD 24 (FM1)
Estimating net operating cash flows
Note that a share of general overheads – office worker costs, for example, is
not a cash flow, unless the general overheads genuinely increase as a result
of this extra machines and extra worker. These you have met as ‘fixed costs’.
Estimating terminal value
When you have finished using the machine, what will you do with it?
Will you sell it? For how much?
How much will it cost for transport?
How much will it cost for repair the building afterward?
Will you have to pay someone to take it away?
Will it enable you to reduce your working capital back to its previous level?
For example Nuke Ltd operates a small nuclear plant, generating electricity
to supply the whole island of Nukealoa. The plant costs $10 million to install.
After 30 years of operations the site will be seriously radioactive. It will cost
$25 million to dispose off the plant safely, and to decontaminating the site.
The cash flow of the capital costs site.
Y0 Y30
Y0 Y1 Y2 …….. Y5
Capex (10,000)
Earning 3,000 3,000 ……. 3,000
Final sale _______ ______ ______ 1,000
Net Cash flow (10,000) 3,000 3,000 …….. 4,000
Net Present Value (NPV)
Consider two examples:
1. Mynabird Curries Ltd install a new machine costing $10,000. This is
increases net earnings by $3,000 a year for 5 years, and is sold at the
end for $1,000. The cost of capital is 11%. The cash flow chart is
Y0 Y1 Y2 …….. Y5
Capex (10,000)
Earning 3,000 3,000 ……. 3,000
Final sale _______ ______ ______ 1,000
Net Cash flow (10,000) 3,000 3,000 …….. 4,000
NPV at 11%
(10,000) today (10,000)
3,000 x 4 years 3,000 x 3.1024 9,307.2
4,000 @ Y5 4,000 x .5935 2374.40
NPV $1,681
This appears to be good investment
Net Present Value (NPV)
Street Repairs Ltd bought a new machine costing $50,000. They pay $40,000
on delivery, and $10,000 one year later. It requires $10,000 of overhaul at
the end of year 3, and is sold for $2,000 at the end of year 5. It increases
net earnings by $20,000 a year for first three years, and $10,000 a year for
the last two years. Cost of capital is 9%
Y0 Y1 Y2 Y3 Y4 Y5
Capex (40) (10)
Earnings 20 20 20 10 10
Overhaul (10)
Final sale 2 __________
Nets cash flow (40) 10 20 10 10 12
Discount factor 1 .917 .841 .772 .708 .649 Total
PV of cash flow (40) 9.17 16.834 7.722 7.084 7.799 8.613
The discount rate at which NPV is exactly zero. The cost of capital at
which the project exactly breaks even. It id called the internal rate of
return, IRR. This is an important number.
It is possible to have two projects with the same NPV at a cost of capital
of 9%, but one project would have a negative NPV at 14%, the other
positive. The first project is more sensitive to interest rate risk. The IRR
figure will tell how much the cost of capital will have to increase, before
the project becomes unprofitable.
Calculating IRR
You find IRR by trial and error procedure as follows:
1. Take the first “cost of capital “ or “discount rate” you are given, or if you
are not given one start with 10%. Calculate NPV.
2. If NPV is negative take half the initial discount rate and calculate NPV
again.
3. If NPV is positive, add 10% to the discount rate, and calculate NPV gain.
4. Repeat process (2) or (3) until you have both a positive and a negative
NPV figure
5. Take an average using the following equation
Y0 Y1 Y2 Y3
(100) 10 50 80
I1 = 9% I2 = 19%