ADVANCED FINANCIAL

MANAGEMENT (AFM)

Optional Module:

Chapter 7- Discounted Cash Flow Techniques

Chapter 7: Discounted cash flow techniques
Part B- Advanced Investment Appraisal

Learning Outcome:

a) Evaluate the potential value added to an organisation arising from a specified capital
investment project or portfolio using the net present value (NPV) model.[3]
Project modelling should include explicit treatment and discussion of:
i) Inflation and specific price variation
ii) Taxation including tax allowable depreciation and tax exhaustion
iii) Capital rationing. Multi-period capital rationing limited to discussion only
iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal
v) Risk adjusted discount rates
vi) Project duration as a measure of risk.
b) Outline the application of Monte Carlo simulation to investment appraisal.[2]
Candidates will not be expected to undertake simulations in an examination context but will be
expected to demonstrate an understanding of:
i) The significance of the simulation output and the assessment of the likelihood of project
success
ii) The measurement and interpretation of project value at risk.
c) Establish the potential economic return (using internal rate of return (IRR) and modified internal rate of
return) and advise on a project’s return margin. Discuss the relative merits of NPV and IRR.[3]

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1- Net present value (NPV)

The net present value (NPV) of a project is the sum of the discounted cash flows
less the initial investment. Projects with a positive net present value should be
undertaken.

Question:
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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 Solution
Time Cash flow Discount factor Present value
0 -150,000 1 -150,000
1 60,000 0.935 56,100
2 60,000 0.873 52,380
3 60,000 0.816 48,960
7,440

The NPV of this project is $7,440. As NPV is positive, Project X should be

undertaken, as it will increase shareholders' wealth.

The effect of inflation

Real cash flows have had the effects of inflation removed and should be discounted
using the real discount rate. Nominal cash flows include the effects of inflation and
should be discounted using the nominal discount rate

Fisher equation =(1 + i) = (1 + r)(1 + h)

Where,
i = nominal (money) rate
r = real rate
h = inflation rate

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

Solution: (1 + i) = (1 + 0.05)(1 + 0.03) = 1.0815

The nominal rate is therefore 8.15%.

Tip: Use 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').

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(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'

Example:
RA Company 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.

• 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.)

Solution:
Calculate cash flows at inflated values:

Year Fixed Other savings Running Net cash flow

income (a) (b) costs ( c) (d) =(a)+ (b) –( c)
$ $ $ $
1 2,500 500 1,000 2,000
2 2,500 [500 x 1.05]=525 [1k x 1.10]= 1,925
1,100
3 2,500 [525 x 1.05]=551 [1.1k x 1.10] 1,841
=1,210
4 2,500 [551 x 1.05]=579 [1.21k x 1.10] 1,748
=1,331

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Calculate the NPV of the project:

Year Cash flow Discount factor (16%)

PV
0 ($5,000) 1.000 ($5,000)
1 2,000 0.862 1,724
2 1,925 0.743 1,430
3 1,841 0.641 1,180
4 1,748 0.552 965
+299
The NPV is positive and the project would appear to be worthwhile.

Allowing for taxation

In investment appraisal, tax is often assumed to be payable one year in arrears,
but you should read the question details carefully. Tax-allowable depreciation
details should be checked in any question you attempt.

Typical assumptions which may be stated in questions are as follows.

(a) An assumption about the timing of payments will have to be made.

(i) Half the tax is payable in the same year in which the profits are earned and
half in the following year. This reflects the fact that large companies have to pay
tax quarterly in some regimes.

(ii) Tax is payable in the year following the one in which the taxable profits are
made. Thus, if a project increases taxable profits by $10,000 in year 2, there will be
a tax payment, assuming tax at (say) 30% of $3,000 in year 3.

(iii) Tax is payable in the same year that the profits arise.
The question should make clear what assumptions you should use.

(b) Net cash flows from a project should be considered as the taxable profits
arising from the project (unless an indication is given to the contrary).

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Example: Taxation
A company is considering whether or not to purchase an item of machinery costing
$40,000 in 20X5. It would have a life of four years, after which it would be sold
for $5,000. The machinery would create annual cost savings of $14,000.

The machinery would attract tax-allowable depreciation of 25% on the RB basis

which could be claimed against taxable profits of the current year, which is soon to
end. A balancing allowance or charge would arise on disposal. The tax rate is 30%.
Tax is payable half in the current year, half one year in arrears. The after-tax cost
of capital is 8%. Should the machinery be purchased?

Answer

Tax-allowable depreciation is first claimed against year 0 profits.

Cost: $40,000

Year Tax allowable RB

depreciation
$ $
(0) 20x5 (25% of cost) 10,000 30,000 (40,000- 10,000)
(1) 20x6 (25% of RB) 7,500 22,500 (30,000 – 7,500)
(2) 20x7 (25% of RB) 5,625 16,875 (22,500 -5,625)
(3) 20x8 (25% of RB) 4,219 12,656 (16,875 – 4,219)
(4) 20x9 (25% of RB) 3,164 9,492 (12,656 – 3,164)

$
Sale proceeds, end of fourth year 5,000 5,000

Less RB, end of fourth year 9,492 (9,492)

Balancing allowance 4,492 4,492

Having calculated the depreciation each year, the tax savings can be computed.
The year of the cash flow is one year after the year for which the allowance is
claimed

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 Year Tax allowable Tax saved Year of tax payment/saving
of depreciation (50% in each)
claim
$ $ 0 /1
0 10,000 3,000 1 /2
1 7,500 2,250 2/3
2 5,625 1,688 3/4
3 4,219 1,266 4/5
4 7,656 2,297
35,000*

*Net cost $(40,000 – 5,000) = $35,000

These tax savings relate to tax-allowable depreciation. We must also calculate the
extra tax payments on annual savings of $14,000

The net cash flows and the NPV are now calculated as follows.
Year Equipment Saving Tax on Tax saved on Net cash Discou Present
Savings tax allowable flow nt value of
depreciation factor cash flow
$ $ $ $ $ 8% $
0 (40,000) 1,500 (38,500) 1.000 (38,500)
1 14,000 (2,100) 2,625 14,525 0.926 13,450
2 14,000 (4,200) 1,969 11,769 0.857 10,086
3 14,000 (4,200) 1,477 11,277 0.794 8,954
4 5,000 14,000 (4,200) 1,782 16,582 0.735 12,188
5 (2,100) 1,148 (952) 0.681 (648)
5,530
The NPV is positive and so the purchase appears to be worthwhile.

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Uncertainty (Risk)
Uncertainty is more difficult to plan, for obvious reasons. There are several ways
in which uncertainty can be dealt with in project appraisal. Three of them –
payback period, sensitivity analysis and discounted payback – will be familiar to
you from earlier studies. Make sure you understand how each of them works.

2- Sensitivity analysis
Example: N company has a cost of capital of 8% and is considering a project with
the following 'most-likely' cash flows.

Year Purchase of plant Running costs Savings

$ $ $
0 (7,000)
1 2,000 6,000
2 2,500 7,000

Required
Measure the sensitivity (in percentages) of the project to changes in the levels of
expected costs and savings.

Solution

Year Discount factor PV of plant PV of PV of PV of net

8% cost running savings cash flow
costs
$ $ $ $
0 1.000 (7,000) (7,000)
1 0.926 (1,852) 5,556 3,704
2 0.857 (2,143) 5,999 3,856
(7,000) (3,995) 11,555 560

The project has a positive NPV and would appear to be worthwhile. The changes
in cash flows which would need to occur for the project to break even (NPV = 0)
are as follows.

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(a) Plant costs would need to increase by a PV of $560; that is, by:

560 x 100% = 8%
7,000

(b) Running costs would need to increase by a PV of $560; that is, by:
560 x 100% = 14%
3,995

(c) Savings would need to fall by a PV of $560; that is, by:

560 x 100% = 4.8%

11,555

Weaknesses of sensitivity analysis

• The method requires that changes in each key variable are isolated.
However, management is more interested in the combination of the effects
of changes in two or more key variables.

• Looking at factors in isolation is unrealistic since they are often

interdependent.

• Sensitivity analysis does not examine the probability that any particular
variation in costs or revenues might occur.

• Critical factors may be those over which managers have no control.

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3-Internal 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.

The IRR is used to calculate the exact discount rate at which NPV is equal to zero.
If calculating IRR manually we use the interpolation method as follows.

(a) Calculate an NPV using a discount rate that gives a whole number and gives an
NPV close to zero.

(b) Calculate a second NPV using another discount rate. If the first NPV was
positive, use a rate that is higher than the first rate; if it was negative, use a rate
that is lower than the first rate.

(c) Use the two NPVs to calculate the IRR. The formula to apply is:

IRR = a + a ___NPV a__ (b-a) %

NPVa- NPVb

This formula is not given in the exam.

where a = the lower of the two rates of return used
b = the higher of the two rates of return used
NPVa = the NPV obtained using rate a
NPVb = the NPV obtained using rate b

The project should be accepted if the IRR is greater than the cost of capital or
target rate of return.

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Example of IRR calculation
A company is considering the purchase of a piece of equipment costing $120,000
that would save $30,000 each year for five years. The equipment could be sold at
the end of its useful life for $15,000. The company requires every project to yield
a return of 10% or more otherwise they will be rejected. Should this equipment
be purchased?

Solution
Step 1- Calculate the annual depreciation.

$120,000 less $15,000) / 5 years = $21,000

Step 2- Calculate the first NPV, using a rate that is two-thirds of the return on
investment. The return on investment would be:

$30,000 less Depreciation of $21,000 = 9,000 = 13.3%

0.5 x (120,000 +15,000) 67,500

Two-thirds of this is 8.9% and so we can start by trying 9%.

The IRR is the rate for the cost of capital at which the NPV = 0.
Year Cash Flow PV factor PV of cash flow
$ 9% $
0 (120,000) 1.000 (120,000)
1-5 30,000 3.890 116,700
5 15,000 0.650 9,750
NPV 6,450

This is fairly close to zero. It is also positive, which means that the actual rate of
return is more than 9%. We can use 9% as one of our two NPVs close to zero.

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Step 3 Calculate the second NPV, using a rate that is greater than the first rate, as
the first rate gave a positive answer.

Let try 12%.

Year Cash Flow PV factor PV of cash flow
$ 12% $
0 (120,000) 1.000 (120,000)
1-5 30,000 3.605 108,150
5 15,000 0.567 8,505
NPV (3,345)

This is fairly close to zero and negative. The real rate of return is therefore greater
than 9% (positive NPV of $6,450) but less than 12% (negative NPV of $3,345).

Step 4 Use the two NPV values to estimate the IRR.

The interpolation method assumes that the NPV rises in linear fashion between
the two NPVs close to 0. The real rate of return is therefore assumed to be on a
straight line between NPV = $6,450 at 9% and NPV = –$3,345 at 12%.

IRR  9 + 6,450______ X (12 - 9)% = 10.98%

(6,450 + 3,345)

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

Mutually exclusive projects

Example:
We have two projects that both require an initial investment of $10,000. Project A
has an IRR of 25% per annum, project B has an IRR of 20% per annum. Which
project should we select?

The answer may appear fairly clear-cut, ie that we select the project with the
higher IRR. However, we are also told that the company's cost of capital is 10%
and are provided with the following data

Time Project A Project B

0 (10,000) (10,000)
1 12,000 1,000
2 625 13,200

Solution
It is incorrect to decide between these alternatives based on IRRs. If we were to
work out the NPVs of these two projects, we could then summarise the findings
as follows.

Project A Project B
NPV @10% 1.426 1.818
IRR 25% 20%

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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.

4 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.

MIRR = PVR x (1 + re) -1

PVI

Where
PVR = the PV of the return phase (the phase of the project with cash inflows)
PVI = the PV of the investment phase (the phase of the project with cash outflows)
re = the cost of capital.

Example of MIRR calculations

Consider a project requiring an initial investment of $24,500, with cash inflows of
$15,000 in years 1 and 2 and cash inflows of $3,000 in years 3 and 4. The cost of
capital is 10%.

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Solution
Calculate PV of the investment phase and the return phase.
Year Cash flow Discount Factor Present Value
$ 10% $
0 (24,500) 1.000 (24,500)
1 15,000 0.909 13,635
2 15,000 0.826 12,390 $30,327
3 3,000 0.751 2,253
4 3,000 0.683 2,049
PVR = Total PV for years 1 to 4 = $30,327
PVI = Cost of investment = $24,500
MIRR = 1/4
30,327
24,500 x (1 + 0.1) – 1 = 16%

The MIRR is calculated on the basis of investing the inflows at the cost of capital.

Advantages of MIRR Disadvantages of MIRR

1-An advantage of MIRR compared to 1-MIRR suffers from the problem that
IRR is that MIRR assumes the it may lead an investor to reject a
reinvestment rate is the company's project which has a lower rate of
cost of capital. IRR assumes that the return but, because of its size,
reinvestment rate is the IRR itself, generates a larger increase in
which is usually untrue. wealth.

2-In many cases where there is conflict 2-In the same way, a high-return
between the NPV and IRR methods, project with a short life may be
the MIRR will give the same preferred over a lower-return project
indication as NPV, which is the correct with
theoretical method. This helps when a longer life.
explaining the appraisal of a
project to managers, who often find
the concept of rate of return easier to
understand than that of NPV.

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