Discounted cash

flow
Discounted cash flow
Discounted cash flow (DCF) is a method
used to estimate the future returns of an
investment. It takes into account the future
value of money — the idea that a dollar that
is ready to be invested now is worth more
than one you are expecting to receive in the
future.

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Outline
I. Net Present Value (NPV)
II. Internal Rate of Return (IRR)
III. Modified Internal of Return (MIRR)

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The Net Present Value (NPV)

The net present value (NPV) of a project is the sum of the

discounted cash flows less the initial investment.

Note: Projects with a positive net present

value should be undertaken.

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What Is Net Present Value (NPV)?

Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. NPV is
used in capital budgeting and investment planning to analyze the profitability
of a projected investment or project.

NPV is the result of calculations that find the current value of a future stream
of payments using the proper discount rate. In general, projects with a
positive NPV are worth undertaking, while those with a negative NPV are
not.

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why Is Net Present Value Important?

• Net present value is important because it allows businesses

and investors to assess the profitability of a project or
investment, taking into account the cost of capital and the
expected rate of return. By discounting future cash flows to their
present value, NPV helps in making informed choices, ensuring
that undertaken projects contribute positively to the overall
financial health and growth.

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Project X requires an immediate investment of $150,000
and will generate net cash inflows of $60,000 for the next 3
years. The project's discount rate is 7%. If NPV is used to
appraise the project, should Project X be undertaken?

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Nominal vs. Real Interest Rate: An Overview

Interest rates represent the cost of borrowing and the return on savings and investing.
They're expressed as a percentage of the total amount of a loan or investment. They can
be the total return lenders receive when they offer loans or the return people earn when
they save and invest.
Nominal Interest Rate
The nominal interest rate is the rate that is advertised by banks, debt issuers, and
investment firms for loans and various investments. It is the stated interest rate paid or
earned to the lender or by investor. So, if as a borrower, you get a loan of $100 at a rate of
6%, you can expect to pay $6 in interest. The rate has been marked up to take account of
inflation.
Real Interest Rate
A real interest rate is the interest rate that is added to the projected rate of inflation to
provide the nominal interest rate. Put simply, this interest rate provides insight into the
actual return received by a lender or investor after a rate of inflation is acknowledged. This8
type of rate is considered predictive when the true rate of inflation is unknown or expected.
 Real and nominal interest rates

When the nominal rate of interest exceeds the rate

of inflation, the real interest rate will be positive. If
the nominal rate of interest is less than the rate of
inflation, the real interest rate will be negative.

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Real rate or nominal rate?

The rule is as follows.

(a) We use the nominal rate if cash flows are expressed in actual
numbers of dollars that will be received or paid at various
future dates (remember: 'money at money’).
(b) We use the real rate if cash flows are expressed in constant
price terms (that is, in terms of their value at time 0).
Remember: 'real at real'.

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 If the real rate of interest is 5% and the expected
inflation is 3%, what is the nominal return?

Formula: (1 + i) = (1 + 0.05)(1
(1+i) = (1+ r)(1+h)
+0.03) = 1.0815
Where
i = nominal (money) rate
r = real rate The nominal rate is
h = inflation rate
This is known as the Fisher equation. therefore 8.15%.
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Effect of inflation

Rice is considering a project which would cost $5,000 now. The

annual benefits, for 4 years, would be a fixed income of $2,500 a
year, plus other savings of $500 a year in year 1, rising by 5%
each year because of inflation. Running costs will be $1,000 in
the first year, but would increase at 10% each year because of
inflating labour costs. The general rate of inflation is expected to
be 7½% and the company's required money rate of return is
16%. Is the project worthwhile? (Ignore taxation.)

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Solution.

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 The internal rate of return (IRR

A project will only be selected if its internal rate of return

exceeds the cost of capital or target rate of return.
The internal rate of return (IRR) of any investment is the
discount rate at which the NPV is equal to zero.
Alternatively, the IRR can be thought of as the return that
is delivered by a project.

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How to Calculate the IRR
The manual calculation of the IRR metric involves the following steps:
1.Using the formula, one would set NPV equal to zero and solve for the
discount rate, which is the IRR.
2.Note that the initial investment is always negative because it
represents an outflow.
3.Each subsequent cash flow could be positive or negative, depending
on the estimates of what the project delivers or requires as a capital
injection in the future.
Because of the nature of the formula, IRR cannot be easily calculated
analytically and instead must be calculated iteratively through trial and
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error or by using software programmed to calculate IRR (e.g., using

The company must calculate the IRR for each project. The initial
outlay (period = 0) will be negative
Solving for IRR is an iterative process using the following equation:
$0 = Σ CFt ÷ (1 + IRR)t
where:
•CF = net cash flow
•IRR = internal rate of return
•t = period (from 0 to last period)

or

$0 = (INVESTMENT) + CF 1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX ÷ (1

+ IRR)X
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 At which discount rate will the net present value become zero?
Project A Given the WACC of 20%

Year 0 1 2 3 4
CASH ($1,000) $400 $400 $400 $400
FLOW

• NPV= ($1,000)+ $400/ (1+IRR) + $400/(1+IRR)^2+$400/(1+IIR)^3+ $400/(1+IIR)^4

• NPV=($1,000)+ $400/ (1+20%) + $400/(1+20%)^2+$400/(1+20%)^3+ $400/(1+20%)^4= 35
WACC is 20% the NPV = 35
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Lets try the WACC of 21%

Year 0 1 2 3 4
CASH FLOW ($1,000) $400 $400 $400 $400

NPV= ($1,000)+ $400/ (1+IRR) + $400/(1+IRR)^2+$400/(1+IIR)^3+

$400/(1+IIR)^4
NPV=($1,000)+ $400/ (1+21% + $400/(1+21%)^2+$400/(1+21%)^3+
$400/(1+21%)^4= 17

IF WACC is 21% our NPV= 17

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NOW LETS TRY 22%
Year 0 1 2 3 4
CASH ($1,000) $400 $400 $400 $400
FLOW

NPV= ($1,000)+ $400/ (1+22%) + $400/(1+22%)^2+$400/(1+22%)^3+ $400/(1+22%)^4=2

If WACC is 22% the our NPV= 2

NPV=0 if IRR=22% of 22% exceeds WACC of 20%

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Modified internal rate of return (MIRR)

The modified internal rate of return is the IRR that would result if it was not
assumed that project proceeds were reinvested at the IRR. The modified
internal rate of return (MIRR) overcomes the problem of the reinvestment
assumption and the fact that changes in the cost of capital over the life of
the project cannot be incorporated in the IRR method.

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Comparison of NPV and IRR

The rule for making investments under the NPV method is that
where investments are mutually exclusive, the one with the
higher NPV should be preferred. Where investments are
independent, all investments should be accepted if they have
positive NPVs. The reason for this is that they are generating
sufficient cash flows to give an acceptable return to providers of
debt and equity finance. This is known as the NPV rule. The
IRR rule states that, where an investment has cash outflows
followed by cash inflows, it should be accepted if its IRR
exceeds the cost of capital. This is because such investments
will have positive NPVs.
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Limitations of the IRR technique

Where we are dealing with independent

investments, the IRR should usually come to the
same decision as the NPV approach. However, it
cannot be used to distinguish between mutually
exclusive investments. This is because it merely
indicates whether or not a project has a positive
NPV. It does not tell us the magnitude of the NPV,
hence it cannot decide which is the superior project.
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What we can see is that project A has the higher IRR of 25%, but it has a
lower NPV at the company's cost of capital. This means that at a 10% cost
of capital, project B is preferable, even though it has the lower IRR.

However, when the cost of capital is 20% project A would be preferred since
project B would then have a NPV of zero while project A must still have a
positive NPV. It can be seen that the decision depends not on the IRR but
on the cost of capital being used. 24
 Modified Internal Rate of Return (MIRR)
Given the cash flow and year

Cash flow ($100) $40 $40 $40

Year 0 1 2 3

WACC 9% 9.7% 10%

IRR 9.7% 9.7% 9.7%
IRR˃WACC IRR=WACC IRR˂WACC
Decision: accept indifferent reject
MIRR ? ? ?

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What Is Modified Internal Rate of Return (MIRR)?

The modified internal rate of return (MIRR) assumes that positive cash flows
are reinvested at the firm's cost of capital and that the initial outlays are
financed at the firm's financing cost. By contrast, the traditional internal rate
of return (IRR) assumes the cash flows from a project are reinvested at the
IRR itself. The MIRR, therefore, more accurately reflects the cost and
profitability of a project.

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 FORMULA FOR MIRR: MIRR= (TV/I)^1/n-1

If WACC is 9% what is the MIRR? If WACC is 10% what is the MIRR?

TV= 40 (1+9%)^2+40 (1+9%)^1+40= TV= 40
131.12 (1+10%)^2+40(1+10%)^1+40=132.4
MIIR= (131.12/100)^1/3= 9.45 0
MIIR= (132.40/100)^1/3= 9.81%
If WACC is 9.7% what is the MIRR?
TV= 40
(1+9.7%)^2+40(1+9.7%)^1+40=132.02
MIIR= (132.02/100)^1/3= 9.70%

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Cash flow ($100) $40 $40
Year 0 1 2

WACC 9% 9.7% 10%

IRR 9.7% 9.7% 9.7%
IRR˃WACC IRR=WACC IRR˂WACC
Decision: accept indifferent reject
MIRR 9.45 9.70% 9.81%
MIRR˃WACC MIRR=WACC IRR˂WACC
IRR˃WACC˃MIR IRR=WACC=MIR IRR˂WACC˂MIR
R R R
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 THANK YOU!
NOBAISAH B. DISIMBAN
QUIZ?