Topic 7.

Cash Flows from Investment Activity Process

1. 2. 3. 4. The financial elements of investment Relevant cash flows from Investment Project Evaluation Time value of money and its influence on cash flows Wor in! with annuities "1" The Financial Elements of Investment that characteri#e the efforts made for and effects of investment are$ % % % % % Estimate of initial investment cost &CF0) 'et incremental after"ta( cash flows (CFn ) Endin! )ash flows (ECFn) Estimated useful life (n) *iscount Rate (r) % % C 0 the initial capital cost of the asset NWC0 the change in net working capital OC the opportunity costs associated with the project

There is an initial investment at t + , (CF0 ) consists of$

There follows an annual stream of after ta( cash flow -enefits &CFn ) consisting of Operating after!ta" cash flow #enefits $a" shield #enefits fro% &epreciation

.t the end of the useful life/ endin! cash flow -enefits received (ECF n ) in the a#sence of ta" issues include$ '( n the esti%ated sal)age )alue in year n for the asset purchased NWC n the net working capital in)est%ent released at the end of the project *urin! the investment 0rocess the cash flows are delivered across the time with varyin! de!rees of uncertainty. That why future cash flows are discounted at a rate that re0resents investors1 assessments of the uncertainty that these cash flows will flow in the amounts and the timeframe e(0ected. The discount rate is defined as the expected rate of return that the market requires in order to attract funds to a particular investment. It reflects the lost opportunity to spend or invest now (opportunity cost) and the various risks assumed ecause we must wait for the funds. The a00ro0riate discount rate can -e esta-lished as$

 200ortunity )ost of )a0ital Re3uired Rate of Return Wei!hted .vera!e )ost of )a0ital 200ortunity cost of ca0ital is the yield that could -e earned on alternative investments with similar ris and maturity. E($ interest rate on -an de0osits/ interest rate of creditor/ avera!e rate of return of industry. .s a discount rate can -e used the RRR+Emin4 I4r/ where Emin % minimal rate of return/ considered 56. !overnment -onds of 4"78 annual income/ I " inflation rate/ r % investment ris 0remium. Re3uired Rate of Return "RRR determined as$

Required Return (%)

Risk Adjusted Discount Rate

Risk Premium

RF

Real Return Expected Inflation Rate Beta of the Project

#isk

In other situations/ as a discount rate/ which determines the time value of money/ de0endin! on the situation can 0artici0ate the followin!$ interest rate on -an de0osits/ interest rate of creditor/ interest rate on financial mar et/ return on firm1s assets/ W.))/ avera!e rate of return of industry. The discount rate selected for the financial analysis is critical to accurate valuation. 2n the level of discount rate de0ends the amount of the 0resent value of cash flows/ thus this/ in fact/ re0resents the cost of the done -usiness. 6o/ the discount rate serves as a criterion used to select 0rofita-le investment 0ro0osals and to reject those un0rofita-le. !"! When we refer to capital investment/ we are referrin! to the firm1s investment in its assets. 9ana!ers must evaluate a num-er of factors in ma in! investment decisions. 'ot only to estimate

how much the firm1s future cash flows will chan!e if it invests in a 0roject/ -ut also must evaluate the uncertainty associated with these future cash flows. The first ste0 in investment analysis 0rocess is to identify the relevant cash flows/ defined as the s0ecific set of cash flows that should -e considered in the decision. $he rele)ant cash flow for a 0roject is the additional free cash flow that the com0any can e(0ect if it im0lements the 0roject. The value of a 0roject de0ends on its free ):s. :irst/ it is necessary to understand -etter the ori!in of these future cash flows. They come from$ ; assets that are already in 0lace/ which are the assets accumulated as a result of all 0ast investment decisions/ and ; future investment o00ortunities. The 0roject1s cash flows are the investment outlays and the annual net cash inflows after an investment 0roject does into o0eration. The -asic cash flow 0attern can -e deconstructed into$ % % % Initial investment (CF0 ) .nnual stream of after"ta( cash flows throu!hout the 0roject life &CF n ) Endin! cash flows (ECF n )

:or each year of the 0roject<s life/ the net cash flow is determined as the sum of the cash flows from each of the three cate!ories. 6ome of these cash flows are estimated in the initiation 0hase/ others in the e(0loitation 0hase and others after the e(0loitation/ in the li3uidation ste0 of the investment. In evaluatin! a 0roject/ it is necessary to focus on those cash flows that occur if and only if the investment 0roject is acce0ted. These cash flows/ called incre%ental cash flows/ re0resent the chan!e in the firm<s total cash flow that occurs as a direct result of acce0tin! the 0roject. This fact su00oses the differentiation in the analysis 0rocess -etween the investment 0roject and the com0any that reali#es these investments. . 0otential 0roject creates value for the firm<s shareholders if and only if the net 0resent value of the incremental cash flows from the 0roject is 0ositive. In 0ractice/ however/ estimatin! these cash flows can -e difficult. "3" To value an investment it is necessary to determine how much this 0ac a!e of cash flows is worth today. This 0rocess em0loys a fundamental finance 0rinci0le % the time value of money. $o calculate the future )alue of a single a%ount we %ust first understand how %oney grows o)er the ti%e. 2nce money is invested it earns an interest rate that com0ensates for the time value of money and for default ris / inflation and other factors. 2ften the interest earned on investment is the com0ound interest/ which is interest earned on interest and on the ori!inal 0rinci0al. In contrast/ sim0le interest is interest earned only on the ori!inal 0rinci0al. 3

The idea that money availa-le at the 0resent time is worth more than the same amount in the future is due to its 0otential earnin! ca0acity. This core 0rinci0le of finance holds that/ 0rovided money can earn interest and any amount of money is worth more the sooner it is received. The time value of money is -ased on the 0remise that one will 0refer to receive a certain amount of money today than the same amount in the future/ -ecause 9oney received today is more valua-le than money received in the future -y the amount of interest we can earn with the money. If =>, today will accumulate to =1,, a year from now/ then the 0resent value of =1,, to -e received one year from now is =>,. $he ti%e )alue of %oney esta-lishes a relationshi0 -etween cash flows received at different times. Time value means that cash on hand is worth more than cash in the future -ecause of the o00ortunity to earn a return. :inancial mana!ers adjust for the time value of money -y calculatin! the future value and the 0resent value. :ormulas for the 0resent value and future value of money 3uantify this time value/ so that different investments can -e com0ared. :uture value and 0resent value are mirror ima!e of each other. Future )alue is the value of startin! amount at a future 0oint in time/ which re0resent the initial amount 0lus interest that is earned durin! the interim 0eriod. *resent )alue is the value of a future amount today assumin! a s0ecific re3uired interest rate for a num-er of years until that future amount is reali#ed. 9oney that are 0aid or received at two different 0oints in time is different/ and this difference is reco!ni#ed and accounted for -y the time value of money analysis. This includes com0oundin! and discountin!. $o calculate the Future )alue (F() and *resent )alue (*() of a single a%ount there can #e used alge#raic+ ta#le or calculator %ethods, $ompoundin% is the 0rocess of determinin! the :? of a sin!le amount + a cash flow or a series of cash flows. :uture value can -e com0uted -y the followin! formula$ F& ' (& ) (*+r) n ' (&)(F&IF r,n), where r % re3uired rate of return of investor &interest rate@ 0er 0eriodA n % num-er of time 0eriods P? % 0resent value of a sin!le amount or the cash flow and :?I: % future value interest factor &which can -e found in financial ta-les@. The &r41@n com0onent of e3uation/ called com0oundin! factor/ is the value time com0onent -ecause it com0ounds the rate of interest. 6o/ :uture ?alue is value in the future of a 0resent cash flow com0ounded at a s0ecified interest rate. -iscountin% is the 0rocess of findin! the 0resent value of a future a sin!le amount/ a cash flow or a series of cash flows. Present value is a today1s money value of a s0ecific future amount. With an 4

investment in new 0lant or e3ui0ment certain cash recei0ts are e(0ected. When the 0resent value of a future 0romised or e(0ected cash 0ayment is calculated/ it is discounted -ecause it is worth less if it to -e received later. In 0resent value analysis the interest rate used in this 0rocess is nown as discount rate. The P? formula is$ (& ' F& )
1 &1 + r@
n

'

F& ) (&IF r,n, ,

where

r % discount rate 0er 0eriodA n % num-er of time 0eriods/ and P?I: % 0resent value interest factor &which can -e found in financial ta-les@. The discount factor/
1 / is the num-er -y which a future cash flow to -e received at time n &1 + r@ n

must -e multi0lied in order to o-tain the current 0resent value. *iscountin! is the inverse to com0oundin!. )om0ound factor causes the value of -e!innin! amount to increase at an increasin! rate/ -ecause it is always !rater than 1 and discountin! causes the 0resent value of a future amount to decrease at an increasin! rate -ecause the discount factor is always less than 1. Ex. =1,,, com0ounded for 1 year at 4 8 interest rate$ :?1+ 1,,,&14,.,4@1+1,4, =1,,, discounted -ac for 2 years at 4 8 interest rate$ P?2+ 1,,,&1B 14,.,4@2+>24/ C, In cases when the discount rate differs from year to year/ the discount factor is calculated as follows$ &1 + r1@ ... &1 + rt @ $ompoundin% more than once per year .n investment<s annual effective rate of interest is necessary when com0oundin! occurs more often than once a year. In this case raises the effective annual interest rate. It is calculated as the followin!$ re' (*4 rnom % nominal interest rateA m % num-er of com0oundin! 0eriods 0er yearA E(. )onsider a stated annual rate of 1,8. )om0ounded yearly/ this rate will turn =1,,, into =11,,. Dowever/ if com0oundin! occurs monthly/ =1,,, would !row to =11,4.E, -y the end of the year/ renderin! an effective annual interest rate of 1,.4E8. 1, 8 is the nominal rate.
rnom m @ !* m
1

In all formulas that com0ute either the 0resent value or future value of money or annuities/ there is an interest rate that is com0ounded at certain intervals of time. This interval of time is assumed to 7

-e 1 year/ -ut/ if it is less than 1 year/ as it fre3uently is/ then there are 2 adjustments that must -e made to the formulas$ 1. The num-er of time 0eriods must -e chan!ed to re0resent the num-er of times that interest is com0ounded. $he nu%#er of years %ust #e %ultiplied #y the nu%#er of co%pounding periods within a year, Thus/ Periods + Fears ) Periods 0er year. 2. The interest rate itself must -e chan!ed to reflect the interest rate 0er time 0eriod. $he annual interest rate %ust #e di)ided #y the nu%#er of co%poundings in a year, Thus/ i 0er + .nnual rate B Periods 0er year. 'ote also that most of the solutions to these formulas are rounded. In this case the 0revious formula for com0utin! :? and P? -ecome the followin!$ F& ' (&)(*4
rnom mn @ , m

1 r (& ' F&) &1 4 nom @ m rnom % nominal interest rateA m % num-er of com0oundin! 0eriods 0er yearA n % num-er of years. !/!

mn ,

where

The 0resent value and future value of an investment is a lum0 sum 0ayment. . series of e3ual lum0 sum 0ayments over e3ual 0eriods of time is called an annuity. Gi e the 0resent value and future value of a sin!le amount/ the 0resent value and future value of an annuity allows com0arin! investments. 5nderstandin! annuities is crucial for understandin! investments that re3uire or yield 0eriodic 0ayments. .n annuity is a series of e3ual 0ayments in e3ual time 0eriods. 5sually/ the time 0eriod is 1 year/ which is why it is called an annuity/ -ut the time 0eriod can -e shorter/ or even lon!er. These e3ual 0ayments are called the periodic rent. The amount of the annuity is the sum of all 0ayments. .n annuity due is an annuity where the 0ayments are made at the -e!innin! of each time 0eriodA for an ordinary annuity/ 0ayments are made at the end of the time 0eriod. 9ost annuities are ordinary annuities. -nalogous to the future )alue and present )alue of a unit+ which is the future )alue and present )alue of a lu%p!su% pay%ent+ the future value of an annuity is the value of e3ually s0aced 0ayments at some 0oint in the future. The 0resent value of an annuity is the 0resent value of e3ually s0aced 0ayments in the future. The Future &alue of an 0nnuity is sim0ly the sum of the future value of each 0ayment. The e3uation for the future value of an ordinary annuity is the sum of the !eometric se3uence$ F(O- = *%t t (1 + r )
t =1 n n t

= *%t1 (1 + r )

n 1

+ *%t 2 (1 + r )

n 2

+ + *%t n C

The future value of an annuity is the sum of the !eometric se3uences shown a-ove/ and these sums can -e sim0lified to the followin! formulas$ The future value of an ordinary annuity is$ (* + r)n ! * F & 1 0 ' ( m t ) 2222222222 r
&1 + r@ n " 1 is called future )alue interest factor of an annuity and is used to find the future value r

of annuity with the ta-le method/ for different com-inations of r and n. 6o/ :?. + . ( :?I:. r/n The (resent &alue of an 0nnuity is the sum of the 0resent value of each annuity 0ayment. 6ince the 0resent value of a lum0 sum 0ayment is sim0ly the future value of that 0ayment divided -y the interest factor &1 4 r@n/ the 0resent value of an annuity is the sum of the 0resent value of each of those 0ayments$ (&10'(mt )
1 1 &1 + r@ n r

P?. " Present ?alue of .nnuity .mount . " annuity 0ayment r " discount rate 0er time 0eriod n " num-er of time 0eriods. The financial ta-le also can -e used for the present value interest factor for an annuity &P?I:.@ to solve 0resent value of annuity 0ro-lems. 6o/ P?. + . ( P?I:. It is nown that for annuity due/ in contrast to ordinary annuities/ annuity 0ayment occur to the -e!innin! to each 0eriod. .nnuities due are more li ely to occur when doin! future value of annuity 0ro-lems than when doin! P?. 0ro-lems. Evaluatin! the 0resent value of a 0romised or e(0ected series of annuity 0ayments that -e!an today would -e a 0resent value of an annuity 0ro-lem. This is less common -ecause annual car or real estate 0ayments usually start at the end of first 0eriod/ ma in! them ordinary annuities.

. perpetuity is an annuity in which the 0eriodic 0ayments -e!in on a fi(ed date and continue indefinitely. Permanently invested &irredeema-le@ sums of money are 0rime e(am0les of 0er0etuities. 6cholarshi0s 0aid 0er0etually from an endowment fit the definition of 0er0etuity. Per0etuity contains an infinite num-er of annual 0ayments.

. cash flow stream is a finite set of 0ayments that an investor will receive or invest over time.

?ery often an investment offers a stream of cash flows which are not either a lum0 sum or an annuity. We can find the 0resent or future value of such a stream -y usin! the 0rinci0le of value additivity/ means that to calculate the P? of an uneven series of cash flows -y findin! the P? of a sin!le amount for each series and then sum the totals.