Investment

appraisal
using DCF
methods
8
Previous chapter
In the previous chapter we covered the treatment of cash flows where was not a factor.

The main techniques of investment appraisal covered we as follows;

1) Relevant cost method

2) Payback period method

3) ROCE
Introduction
This chapter will look into investment appraisal techniques where time adjusted values are taken into
consideration. The techniques discussed in this chapter are;

Discounted cash flow method (DCF)

2) Net Present Value (NPV) method

3) Internal rate of return (IRR)

4) NPV and IRR comparison

5) Assessment of DCF method of project appraisal

1) Discounted cash flow concept
DCF method takes into account;

1) timing of cash flow &

2) profitability of the project

DCF method focuses on the cash flow of the project and not the accounting profits.

Future incremental cash flows are accounted for and sunk cost is irrelevant in this method.
1.1) Discounting
Present value of the cash flow which is equivalent to the cash flow generated in the future.

It means that the future value will be brought down to present value.

Discounting answers ; ‘'What must you receive now to be equivalent to that future
amount?’’
1.1) Discounting
What is the present value of the following cash flows:

(a) $10,000 received in three years if interest rates are 4%

(b) $10,000 received in ten years if interest rates are 4%
(c) $10,000 received in three years if interest rate are 10%
1.1) Discounting
(a) $10,000 received in three years if interest rates are 4%
P = $10,000 × 1/(1 + 0.04)3 = $8,890

(b) $10,000 received in ten years if interest rates are 4%

P = $10,000 × 1/(1 + 0.04)10 = $6,756

(c) $10,000 received in three years if interest rate are 10%

P = $10,000 × 1/(1 + 0.10)3 = $7,513
NOTE: The higher the interest rate the lower will be the amount. (a& c)

More the time period, the smaller the present value. (a&b)
1.1) Discounting
Which of the following offers is better?

(a) $4,000 received in three years if interest rates are 5%

(b) $6,000 received in seven years if interest rates are 6%
1.1) Discounting
(a) $4,000 received in three years if interest rates are 5%

P = $4,000/(1 + 0.05)3 = $3,455

(b) $6,000 received in seven years if interest rates are 6%

P = $6,000/(1 + 0.06)7 = $3,990

Offer (b) is preferable as it has the higher present value.

1.3) Using annuity tables.
Using annuity tables, calculate the present value of the following cash flows:

(a) $2,000 received for ten years, with the first flow occurring at time 2. Discount rate =
10%
(b) $3,000 received for six years with the first flow occurring at time 4. Discount rate =
6%

NOTE: Do not make a mistake with the time period into consideration.
Ans
(a) $2,000 received for ten years, with the first flow occurring at time 2. Discount rate =
10%

A 'normal' ten-year annuity is

received in years 1–10.
This one is received in years
2–11, which is like 1–11,
but omitting year 1.

The present value of the flows is therefore:

5.586 × $2,000 = $11,172.
Ans cont..
(b) $3,000 received for six years with the first flow occurring at time 4. Discount rate =
6%

A 'normal' six-year annuity is

received in years 1–6.
This one is received in years
4–9, which is like 1–9, but
omitting years 1–3.

The present value of the flows is therefore: 4.129 × $3,000 = $12,387.

1.2) why use discounting tables?
The previous examples worked out present values from first principles ie to convert an
amount received at time 3 when interest rates are 10%, multiply by the discount factor of
1/(1 + 0.1)3, or 0.751.
Use discounting tables to reduce the computation.

Using discounting tables will round off the answer in the same way as the examination team.
1.4) Annuity factors that are not
present in the annuity tables.
Very occasionally, you might have to deal with a discount rate that is not on the discount
tables, eg 10.5%, or for periods of over 15 years.

There is a formula at the top of the annuity tables:

A company will receive $10,000 for 25 years. Discount rate = 15.5%. What is the
present value of the cash flows?

A $157
B $62,760
C $205,953
D $250,000
Ans
 


1-1.15525  = 6.276


 0.155 

Therefore, PV = 10,000*6.276
1.5) Perpetuities
A perpetuity is a constant annual amount received forever.

Some cash flows approximate to perpetuities eg a lease of 99 years.

Present value of an annuity of 1 =

1  (1 + r)-n
r

In the formula above, as n gets very large, the (1 + r)-n becomes very small and the
formula becomes
1
Discount factor for a perpetuity = r
A company will pay rent of $25,000 for 99 years. The rent will begin at time 3.

Using a discount rate of 9% and assuming the rental period can be approximated to a
perpetuity, what is the present value of the rent payments?

A $170,525 B $214,500
C $233,800 D $277,775
Ans
A company will pay rent of $25,000 for 99 years. The rent will begin at time 3. Discount rate = 9%

Answer C

A 'normal' perpetuity is
For years 1 – ∞. This
one is received in years
3 – ∞ so years 1 and 2 have
to be omitted.

PV of the rental payments = 9.352 × 25,000 = $233,800

 2) Net Present value
Net present value (or NPV) of a project is the value obtained by discounting all cash
outflows and inflows by a chosen target rate of return or cost of capital and adding them.

• Discounting cash flows to their present values means that flows occurring at different
times can be validly compared.
• If the net of the inflows and outflows is positive (a positive NPV), the project is
worthwhile as the investor will be richer (increase in shareholders wealth).
• If the NPV is negative then the project is not worthwhile and should be rejected.

NPV is the difference between (PV of the cost – PV of the benefits)

A new machine will cost $50,000 and will produce net cash inflows of:
Year 1 $20,000
Year 2 $40,000
Year 3 $25,000

The machine can be sold for $10,000 at the end of the project.
Using the NPV method and a discount rate of 10%, is the project worthwhile?
 Ans
The cash flows and NPV calculation can be set out as:

Because the NPV is positive the project is worthwhile and should be accepted. It should increase shareholder
wealth.
 Central assumption of NPV and
IRR
• It is implicit in NPV calculations that cash receipts are reinvested at the discount rate.

• It is not implicit in IRR calculations that cash receipts are reinvested at the internal
rate of return. There is no guarantee in IRR that the funds will be reinvested.

• Neither assumption might be valid in practice and so there is a flaw in each method.
NPV with relevant cost: advanced
problem
A new machine cost $500,000 and will produce net inflows of $100,000 pa for eight years,
starting at time 3.
The machine will be located in an old building which cost $1 million six years ago. The building
could be sold now for $1.5 million or for $4.0 million at the end of the project.
In addition to any costs above, to use the manufacturing process the company will have to pay a
royalty of $1,000 pa for 100 years, starting now, for the use of a patent.

Using the NPV method and a discount rate of 10%, is the project worthwhile?
 Ans

Because the NPV is negative the project is not worthwhile and should be rejected. It will reduce shareholder wealth.
Internal rate of return (IRR)
IRR of an investment is the cost of capital at which NPV would be exactly $0.

It is an alternate to the NPV method.

As per this method an investment project will be accepted if calculated IRR exceed a target rate of
return.

Calculation of IRR is based on hit and miss technique known as interpolation method.

IRR assumes linear relationship between two NPVs.

Steps to calculate IRR
Step 1: Calculate NPV of a project/investment using cost of capital (Discounting factor) or target rate
given in the question.

Step 2: Calculate the NPV using a second discount rate.

Project/Investment NPV BASIS ANSWER
1 CALCULATION (NPV) Cost of capital positive
2 CALCULATION (NPV) ASSUME higher rate than Positive / negative
Ke
Project/Investment NPV BASIS ANSWER
1 CALCULATION (NPV) Cost of capital negative
2 CALCULATION (NPV) ASSUME lower rate than Positive / negative
Ke
Steps to calculate Step 3: Use both NPV values to calculate IRR.

IRR
Steps to calculate IRR
NOTE: Even if you have both NPV 1 and NPV 2 as positive or negative. The answer won’t change.
The formula will interpolate and extrapolate the values.
Relationship between NPV,
discount rate and IRR.
1) For 1st calculation of NPV (i.e. NPV 1) ; if the NPV is positive, then;

Discount rate is smaller than IRR

2) For 1st calculation of NPV (i.e. NPV 1) ; if the NPV is negative, then;

Discount rate is greater than IRR

NOTE: IRR is not superior than NPV as it does not provide a clear decision rule, nor does it state
the reinvestment of the funds.
Understanding IRR
Work out the NPV at two discount rates, eg 5 and 15% (or other rates); try to get one
+ve and one –ve NPV.
Understanding IRR cont.
You then have to assume the NPV moves in a straight line between the two rates – so the answer
will be an estimate.
 Understanding IRR cont..
Use the formula of IRR.

IRR = a% + NPVa × (b%  a%)

NPVa  NPVb
Where,

where
a% = lower rate tried
b% = higher rate tried
Na = NPV at a%
Nb = NPV at b%

IRR = 5 + (1,000/(1,000 –(–500))) × (15 – 10)

= 11.7%
The project has the following cash flow:

Estimate the IRR:

a) 5% and 15%
b) 5% and 8%
 (a) IRR using 5% and 15%
IRR = 5% + 890 /(890 – ( –880)) x (15% – 5%) = 10%
(b) IRR using 5% and 8%
IRR = 5% + 890 /(890 – 302)) x (8% – 5%) = 9.5%
• Different starting points will give different IRR estimates.
• NOTE: Try to get one +ve and one –ve NPV, but don't spend excessive time
seeking that.
 Summary
• When cash flow patterns are conventional, both methods give the same accept or
reject decision for a project.
• The IRR method is more easily understood (but if NPV is not understood can IRR be
properly understood?).
• IRR ignores the relative sizes of investments.
• The NPV method is superior for ranking mutually exclusive projects.
• If discount rates change over the life of the project, this can be incorporated easily
into NPV calculations, but not into IRR calculations.
 Summary cont.
• Where cash flow patterns are non-conventional, there may be several IRRs which decision
makers must be aware of to avoid making the wrong decision.
• Despite the advantages of the NPV method over the IRR method, the IRR method is widely
used in practice.
 DCF methods advantage
DCF methods of appraisal have a number of advantages over other appraisal methods:
• Cash flow based.
• The time value of money is taken into account.
• All of a project's cash flows are taken into account.
• DCF methods allow for the timing of cash flows.
• There are universally accepted methods of calculating the NPV and IRR.
 Problems with DCF methods
• Future cash flows may be difficult to forecast and all of a project's cash flows should
be taken into account.
• The basic decision rule 'accept all projects with a positive NPV' will not apply when
the capital available for investment is rationed. (See Chapter 11.)
• The cost of capital (discount rate) may be difficult to estimate.
The cost of capital may change over the project's life.
• The NPV method assumes that businesses seek to maximise the wealth of their
shareholders. This may conflict with the interests of other stakeholders.
To be cont..
Multiple IRR problem

Graphical representation

Mutually exclusive projects

How to calculate IRR of
perpetuity.
By definition IRR = the discount rate where the NPV = 0

PV of a perpetuity = Annual inflow/r

For a perpetuity, if NPV = 0, then:

Initial investment = Annual inflow/r

r, the IRR = Annual inflow/Initial investment
Mutually exclusive projects.
A building company can either build a house or an apartment block on a piece of land. Details are:

If the company uses a discount rate of 10%:

(a) Calculate each investment's NPV and IRR.
(b) Compare your answers and advise which project should be adopted.
House IRR>apartments IRR; house NPV<apartments NPV

Look at the incremental investment:

• Both IRRs are > than 10%
• Both have +ve NPV
• Can only choose one
• Choose highest NPV with mutually exclusive investments as this maximises shareholder
wealth
 Multiple IRR problem
• A set of cash flows has up to as many IRRs as there are changes in the cash flow
direction.
• A conventional project has an initial negative flow (cost of the investment) followed by
positive flows (income from the investment). Therefore only one IRR.
• A project could easily have an initial negative flow, then positive flows, then a final
negative flow (eg clean-up costs). Two changes in cash flow direction means zero,
one or two IRRs.
 Summary
• When cash flow patterns are conventional, both methods give the same accept or
reject decision for a project.
• The IRR method is more easily understood.
• IRR ignores the relative sizes of investments.
• The NPV method is superior for ranking mutually exclusive projects.
• If discount rates change over the life of the project, this can be incorporated easily
into NPV calculations, but not into IRR calculations.