Chapter 3:

Discounted cash flow techniques

The time value of money – this concept means that the amount of money received today is worth more
than the same sum received in the future which means it has time value. This occurs because of
potential for earnings interest/cost of finance, the impact of inflation and the effect of risk. If a capital
investment is to be justified, it needs to earn at least a minimum amount of profit so that the return
compensates the investor for both the amount invested and also for the length of time before the
profits are made. The funds are also subjected to a loss of purchasing power over time due to inflation.
The earlier cash flows are received, the more certain they are as there are no events that are likely to
prevent payment but over time this certainty reduces which makes the earlier cash flows to be
considered more valuable.

compounding

compounding calculates the future or terminal value of a given sum invested today for a number of
years.

F = P (1 + r) ^-n

Where F = Future value after n periods

P = Present or initial value

r = Rate of interest per period

n = Number of periods

The terminal value is the value, in n years’ time, of a sum invested now, at an interest rate of r%

If $5,000 is to be invested now for six years, at an interest rate of 5%pa, what is the value of the
investment after six years?

What is the present value of $115,000 receivable in nine years’ time if r = 6%?

Net present value

The NPV is the sum of the present values of all cash flows that arise as a result of the project. It
represents the surplus after deducting the initial investment. If the NPV is positive the project is
accepted and if it is negative it is rejected. When assessing more than one project, then the project with
the highest NPV is accepted.

Assumptions used in discounting:

 All cash flows occur at the start or end of the year

 Initial investments occur at T0
 Other cash flows start one year after T0
The cash flows for a project have been estimated as follows:

Year $

0 (25,000)
1 6,000
2 10,000
3 8,000
4 7,000

The cost of capital is 6%.

Calculate the NPV of the project and decide if it should be accepted.

An organisation is considering a capital investment in new equipment. The estimated cash flows are
given as follows:

Year Cash flow

0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000

The company’s cost of capital is 9%. Calculate the NPV of the project to assess whether it should
be undertaken.

Advantages of NPV:

 Theoretically superior as it considers time value of money

 It is an absolute measure of return
 It is based on cash flows not profits
 It considers the whole life of the project
 It should lead to maximization of shareholder wealth

Disadvantages:

 It is difficult to explain to managers

 It requires knowledge of the cost of capital
 It is relatively complex
Discounting annuities:

An annuity is a constant annual cash flow for a number of years. The annuity factor is the sum of the
individual discounting factors. The present value of an annuity can be calculated using:

PV= annual cash flow x annuity factor

A payment of $1,000 is to be made every year for three years, the first payment occurring in one year’s
time. The interest rate is 10%. What is the present value of the annuity?

A payment of $3,600 is to be made every year for seven years, the first payment occurring in one
year’s time. The interest rate is 8%. What is the Present value of the annuity?

Discounting perpetuities:

A perpetuity is an annual cash flow that occurs forever. It is a cash flow continuing for the foreseeable
future and the PV of a perpetuity is calculated using:

PV = cash flow/r

PV = cash flow x 1/r

Where 1/r is the perpetuity factor

The PV of a growing perpetuity is found using:

PV = cash flow at T1 x 1/r-g

1/r-g is the perpetuity factor with growth

Calculate the present value of the following, assuming a discount rate of 10%:

i) $3,000 received in one year’s time and forever

ii) $3,000 received in one year’s time, then growing by 2% pa in perpetuity

Use of annuity factors and perpetuity factors both assume that the first cash flow will be occurring in
one year’s time. Annuity or perpetuity factors will discount the cash flows back to give value in one year
before the first cash flow arose.

In some cases, the regular cash flow can arise in year 0 rather than in year 1. This will require calculation
of PV ignoring the payment at T0 when considering number of cash flows and then adding one to the
annuity or perpetuity factor.
A 5 year $600 annuity is starting today. Interest rates are 10%. Find the PV of the annuity.

A perpetuity of $2,000 is due immediately. The interest rate is 9%. What is the PV of the annuity?

Delayed annuities and perpetuities:

Some regular cash flows may start later than T1. This requires applying the appropriate factor to the
cash flows as normal and discounting the answer back to T0

The internal rate of return (IRR)

The IRR is the discount rate at which the NPV of the project/investment is zero. This means the
investment will only be accepted if the IRR is greater than the cost of capital.

IRR = L + (NL /NL-NH) x (H–L)

Where:

L = lower rate of interest

H = Higher rate of interest

NL = NPV at lower rate of interest

NH = NPV at higher rate of interest

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%. Calculate the IRR

A business undertakes high risk investments and requires a minimum expected rate of return of 17% pa
on its investment. A proposed capital investment has the following expected cash flows:

Year $

0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000
i) Calculate the NPV of the project at cost of capital of 15%
ii) Calculate the NPV of the project at cost of capital of 20%
 iii) Use the NPV calculated above to estimate the IRR of the project and recommend whether
the project should be undertaken, purely based on financial considerations.

Advantages of IRR:

 It considers the time value of money

 It is a percentage and therefore easily understood
 It uses cash flows rather than profits
 It considers the whole life of the project
 It means a firm selecting projects where the IRR exceeds the cost of capital will lead the
maximizing of shareholder wealth

Disadvantages:

 It is not a measure of absolute profitability

 Interpolation only provides an estimate and an accurate estimate requires the use of a
spreadsheet programme
 It is fairly complicated to calculate
 Non-conventional cash flows may give rise to multiple IRRs which means the interpolation
method would not be suitable to use.

Find the IRR of the project below and advise whether the project should be undertaken purely based
on the financial calculations and assuming that the entity requires a minimum rate of 17%: