3 Investment Appraisal Discounted Cash Flow Techniques

Investment appraisal –
Discounted cash flow

techniques
The time value of money 03
Potential
Money received today is worth for
more than the same sum received Earning
02
in the future, i.e. it has a time value Risk
01
Inflation
Compounding
A sum invested today will earn interest.
Compounding calculates the future value of a given sum invested today for a number of years.
Where :
FV ‐ Future value.
PV ‐ Present value.
r ‐ Rate of interest or cost of capital per compounding period.
n ‐ Number of compounding periods (years)
Illustration - 1
You have $5,000 to invest now for 2 years at an interest rate of 12%
pa. What will be the value of the investment after 2 years?
Illustration - 2
You have $5,000 to invest now for 2 years at an interest rate of 12%
pa, compounded half yearly. What will be the value of the investment
after 2 years?
Discounting
The opposite of compounding, where we have the future value (eg an expected
cash inflow in a future year) and we wish to consider its value in present value
terms.
Discounting a single sum
What is the PV of $115,000 receivable in nine years' time if r = 6%?

Discounting Factor
What is the PV of $115,000 receivable in nine years' time if r = 6%?

Net Present Values (NPV)
The NPV of the

project is the
sum of the PVs
of all cash flows
that arise as a
result of doing
the project.
The NPV of the Decision Rule
project is the If NPV of the project,

sum of the PVs discounted at cost of
of all cash flows capital, is positive
that arise as a then Accept the
result of doing project,
the project.
Else Reject the
Project.
Illustration
Finance Our CO Invest
Illustration
1 NPV is positive – the project is financially viable
NPV gives the impact of the project on

2
shareholder wealth.
2 or more mutually exclusive projects under

3 consideration it should choose the one with the
highest NPV
Lead to
Advantages1 Difficult to maximisation
explain to of
Dis advantages1 managers shareholder
wealth.
Determination
Based on
of Cost of
cash flows
capital will
not profits
be difficult
Absolute Takes in to
measure of account the
return time value of
money
Internal Rate of Return (IRR) cashflow rate of return
IRR is the total discounted rate of return offered by an

investment over its life.
The IRR represents the discount rate at which the NPV of

an investment is zero. As such it represents a breakeven
cost of capital.
Internal Rate of Return (IRR)
IRR is the total discounted rate of return offered by an

investment over its life. Decision Rule
The IRR represents the discount rate at which the NPV of If IRR of the project >
an investment is zero. As such it represents a breakeven Cost of capital,
cost of capital. Accept the project.
Else Reject the

Project
Calculating the IRR using linear interpolation
The steps in linear interpolation are:

(1) Calculate two NPVs for the project at two different costs of capital
(2) Use the following formula to find the IRR:
A potential project’s predicted cash flows give a NPV of $50,000 at a discount

rate of 10% and –$10,000 at a rate of 15%.
Advantages
It is based on cash flows, not accounting
profits.
A percentage is easily understood.
Consider the time value of money.

Disadvantages
Non‐conventional cash flows may give

rise to multiple IRRs.
Since it is a relative measure (% on

investment) ignores the relative sizes of
investments.
Disadvantages
Not suitable for mutually exclusive
projects decisions
The reinvestment assumption

underlying the IRR method cannot be
substantiated.
Non‐conventional cash flows may give

rise to multiple IRRs.
Since it is a relative measure (% on

investment) ignores the relative sizes of
investments.
Consistent Cashflow
Annuity: If Consistent cashflow for a certain Period.
e.g Y1‐5 or Y3‐7
Perpetuity: If Consistent cashflow for infinite period

e.g. Y1‐∞ or Y3‐∞
Normal Annuity
T0 T1 T2 T3 T4
Cashflow 30000 30000 30000 30000
DF @ 10% 0.909 0.826 0.751 0.683

Advanced Annuity
Delayed Annuity
Perpetuity
Advanced Perpetuity
Delayed Perpetuity
Perpetuity with Growth
A perpetuity of $2,000 (T0 terms) starting in 1 year's time, growing at 3% per annum.
Interest rates are 10%
Delayed Perpetuity with Growth
A perpetuity of $2,000 (T5 terms) starting in six year's time, growing at 3% per annum.
Interest rates are 10%

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Investment appraisal –

Discounted cash flow

What is the PV of $115,000 receivable in nine years' time if r = 6%?

What is the PV of $115,000 receivable in nine years' time if r = 6%?

The NPV of the

project is the If NPV of the project,

NPV gives the impact of the project on

2 or more mutually exclusive projects under

IRR is the total discounted rate of return offered by an

The IRR represents the discount rate at which the NPV of

IRR is the total discounted rate of return offered by an

Else Reject the

The steps in linear interpolation are:

A potential project’s predicted cash flows give a NPV of $50,000 at a discount

A percentage is easily understood.

Consider the time value of money.

Non‐conventional cash flows may give

Since it is a relative measure (% on

The reinvestment assumption

Non‐conventional cash flows may give

Since it is a relative measure (% on

Perpetuity: If Consistent cashflow for infinite period

Cashflow 30000 30000 30000 30000

DF @ 10% 0.909 0.826 0.751 0.683

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