Cash Flow Evaluation

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Cash Flow Evaluation

© All Rights Reserved

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Hugh Miller

Colorado School of Mines

Mining Engineering Department

Fall 2013

Introduction

As we have addressed the fundamental concepts associated with

engineering economics and cash flows, is now time to convert these

estimates into measures of desirability as a tool for investment decisions.

We will use the following criteria:

Annual Value

Benefit / Cost Ratio

Payback period

Internal Rate of Return

Variations of IRR

Present Value

The Present Value or Present Worth method of evaluating

projects is a widely used technique. The Present Value

represents an amount of money at time zero representing

the discounted cash flows for the project.

PV

T=0

The Net Present Value of an investment it is simply the difference between cash

outflows and cash inflows on a present value basis.

In this context, the discount rate equals the minimum rate of return for the

investment

Where:

NPV = Present Value (Cash Benefits) - Present Value (Cash Costs)

Initial Investment:$100,000

Project Life:

10 years

Salvage Value: $ 20,000

Annual Receipts: $ 40,000

Annual Disbursements: $ 22,000

Annual Discount Rate: 12%

What is the net present value for this project?

Is the project an acceptable investment?

Annual Receipts

$ 226,000

Salvage Value

$20,000(P/F, 12%, 10)

6,440

Annual Disbursements

-$124,000

$ 8,140

Future Value

The future value method evaluates a project based

upon the basis of how much money will be

accumulated at some future point in time. This is

just the reverse of the present value concept.

FV

T=0

Initial Investment:$100,000

Project Life:

10 years

Salvage Value: $ 20,000

Annual Receipts: $ 40,000

Annual Disbursements: $ 22,000

Annual Discount Rate: 12%

What is the net future value for this project?

Is the project an acceptable investment?

Annual Receipts

$ 20,000

-$ 386,078

Initial Investment

$20,000(year 10)

Annual Disbursements

$ 701,960

Salvage Value

-$ 310,600

$ 25,280

Can be used to compare with future value of other projects

PV/FV Example

No theoretical difference if project is evaluated in

present or future value

PV of $ 25,282

$25,282(P/F, 12%, 10)

$ 8,140

FV of $8,140

$8,140(F/P, 12%, 10)

$ 25,280

Future or present value methods are ideally suited

for cash flows that are non-uniform over the life of

the investment (as most are). Simply treat each

year separately.

T=0

Annual Value

project in terms of its annual value or cost. For

example, it may be easier to evaluate specific

components of an investment or individual

pieces of equipment based upon their annual

costs as the data may be more readily available

for analysis.

purchase which will generate annual benefits in

the amount of $10,000 for a 10 year period, with

annual costs of $5,000. The initial cost of the

machine is $40,000 and the expected salvage is

$2,000 at the end of 10 years. What is the net

annual worth if interest on invested capital is

10%?

Benefits:

125

-$ 5,000

Investment:

Costs:

$10,000

Salvage

-$ 6,508

-$1,383

earn less than the acceptable rate of 10%, therefore

the project should be rejected.

Benefit/Cost Ratio

profitability index and is defined as the ratio of

the sum of the present value of future benefits to

the sum of the present value of the future capital

expenditures and costs.

Project A

$500,000

Project B

$100,000

$300,000

$ 50,000

$200,000

$ 50,000

Benefit/Cost Ratio

1.67

2.0

Payback Period

This is one of the most common evaluation criteria used by engineering

and resource companies.

The Payback Period is simply the number of years required for the cash

income from a project to return the initial cash investment in the project.

The investment decision criteria for this technique suggests that if the

calculated payback is less than some maximum value acceptable to the

company, the proposal is accepted.

The following example illustrates five investment proposals having

identical capital investment requirements but differing expected annual

cash flows and lives.

Payback Period

Example

Calculation of the payback period for a given investment proposal.

a) Prepare End of Year Cumulative Net Cash Flows

b) Find the First Non-Negative Year

c) Calculate How Much of that year is required to cover the previous period

negative balance

d) Add up Previous Negative Cash Flow Years

Initial

Investment

Alternative A

(45,000) 10,500

11,500

10

(45,000) (34,500) (23,000) (10,500)

Pay Back Period

Fraction of First Positive Year

Pay Back Period

4

5

6

7

b

0.78

3.78

c)

0.78 = 10,500/13,500

d)

3 + 0.78

Example:

Calculate the payback period for the following investment proposal

Initial

Investment

Alternative A

(120)

10

10

50

4

5

6

7

10

50

50

50

50

50

50

(120) (110) (100) (50)

0

50

100

150

200

250

300

Fraction of First Positive Year

Pay Back Period

50

1.00

4.00

Example:

Calculate the payback period for the following investment proposal

Initial

Investment

Alternative A

(120)

10

10

50

4

5

6

7

10

50

50

50

50

50

50

(120) (110) (100) (50)

0

50

100

150

200

250

300

Fraction of First Positive Year

Pay Back Period

50

1.00

4.00

Example:

Calculate the payback period for the following investment proposal

Initial

Investment

Alternative A

(120)

10

10

50

4

5

6

7

10

50

50

50

50

50

50

(120) (110) (100) (50)

0

50

100

150

200

250

300

Fraction of First Positive Year

Pay Back Period

50

1.00

4.00

Example:

Calculate the payback period for the following investment proposal

Initial

Investment

Alternative A

(250)

86

50

77

4

5

6

7

10

41

70

127

24

40

(250) (164) (115) (38) 14

55

124

252

276

282

322

Fraction of First Positive Year

Pay Back Period

52

0.73

3.73

Example:

Calculate the payback period for the following investment proposal

Initial

Investment

Alternative A

(250)

86

50

77

4

5

6

7

10

41

70

127

24

40

(250) (164) (115) (38) 14

55

124

252

276

282

322

Fraction of First Positive Year

Pay Back Period

52

0.73

3.73

Example:

Calculate the payback period for the following investment proposal

Initial

Investment

Alternative A

(250)

86

50

77

4

5

6

7

10

41

70

127

24

40

(250) (164) (115) (38) 14

55

124

252

276

282

322

Fraction of First Positive Year

Pay Back Period

52

0.73

3.73

When calculating the payback period for a new project we typically

have several years of negative cash flows (investment) prior to positive

cash flows.

Two Approaches: Total Payback and Payback After 1st Production

The total payback period is calculated from the start of the project and

represents the commitment of the investor throughout the pre-production

period, particularly the opportunity cost associated with the investment

during this period.

Disadvantages:

A)

B)

This criterion fails to consider cash flows after the payback period,

therefore, it cant be regarded as a suitable measure of profitability.

It doesnt consider the magnitude or timing of the of cash flows during the

payback interval.

Advantages

1.

Simple and easy to calculate, providing a simple number which can be used

as an index of proposal profitability.

2.

The shorter the payback the less risk associated with the investment

Projects with short payback will minimize opportunity risk since early

cash flows will be returned to the firm within a short span of time. (Liquidity)

4.

Projects with life greater than the payback period will contribute profit to

the firm

Engineering Economics

EIT Review

IRR & Discount Rates

In project evaluation, any reference to rate of return normally refers to

the discounted cash flow return on investment (DCF-ROI) or the

discounted cash flow rate of return (DCF-ROR)

These terms are special versions of the more generic term, Internal

Rate of Return (IRR) or sometimes called marginal efficiency of capital

Besides NPV, is probably the most common evaluation technique used

in the minerals industry

Internal Rate of Return refers to the interest rate that the investor

will receive on the investment principal

IRR is defined as that interest rate (r) which equates the sum of

the present value of cash inflows with the sum of the present value

of cash outflows for a project. This is the same as defining the IRR

as that rate which satisfies each of the following expressions:

PV cash inflows - PV cash outflows = 0

NPV = 0 for r

PV cash inflows = PV cash outflows

unless the annual cash flows subsequent to the investment take the form of

an

annuity. The following examples illustrate the calculation procedures for determining

the internal rate of return.

Example

Given an investment project having the following annual cash flows; find the IRR.

Year

Cash Flow

0

(30.0)

1

(1.0)

2

5.0

3

5.5

4

4.0

17.0

20.0

20.0

(2.0)

10.0

Solution:

Step 1. Pick an interest rate and solve for the NPV. Try r =15%

NPV

+ 17(P/F,5,15) + 20(P/F,6,15) + 20(P/F,7,15) - 2(P/F,8,15) + 10(P/F,9,15)

= + $5.62

Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a

higher interest rate in order to reduce the NPV value.

Step 2. If r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high.

Step 3. By interpolation the correct value for the IRR is determined to be r =18.7%

Using Excel you should insert the following function in the

targeted cell C6:

Analysis

The acceptance or rejection of a project based on the IRR

criterion is made by comparing the calculated rate with the required rate

of return, or cutoff rate established by the firm. If the IRR exceeds the

required rate the project should be accepted; if not, it should be rejected.

If the required rate of return is the return investors expect the

organization to earn on new projects, then accepting a project with an

IRR greater than the required rate should result in an increase of the

firms value.

Analysis

There are several reasons for the widespread popularity of the IRR

as an evaluation criterion:

that it provides a single figure which can be used as a

measure of project value.

Most managers and engineers prefer to think of economic

decisions in terms of percentages as compared with

absolute values provided by present, future, and annual

value calculations.

Analysis

Another advantage offered by the IRR method is related to the

calculation procedure itself:

As its name suggests, the IRR is determined internally for

each project and is a function of the

magnitude and timing of

the cash flows.

Some evaluators find this superior to selecting a

rate

prior to calculation of the criterion, such as in the profitability

index and the present, future, and

annual value

determinations. In other words, the

IRR eliminates the need to

have an external interest rate supplied for calculation purposes.

One of the disconcerting aspects associated with the internal rate of return is

that more than one interest rate may satisfy the calculation. The solution

procedure for IRR is essentially the solution for an nth degree polynomial of the

form:

NPV = 0 = A0 + A1X + A2X2 + A3X3 + .... + AnXn

where X = 1/(1 + r)

For a polynomial of this type there may be n different real roots, or values of

r, which satisfy the equation. Multiple positive rates of return may occur when

the annual cash flows have more than one change in sign.

The following example illustrates the possibility of multiple rates which satisfy the definition of IRR:

Suppose a mining operation has a remaining life of eight years, but an investment is considered to increase the production rate. This will result in depleting the

deposit in six years. Assuming the following cash flows, is the investment justified?

Because there are two sign reversals in the cash flows, Descartes Rule of Signs indicates there are a

maximum of two real roots to the IRR polynomial.

Solving for these roots by trial and error yields the following:

Graphically this appears as shown in the following figure:

The rates at which NPV = 0 are, by definition, the internal rates of return. By interpolation, the two solving rates of return for this example are approximately 4.5 and 12.3%

Should the firm invest in the project or not?

If both rates were above the firm's required rate of return there would be no

problem and the firm would accept the project.

However, what if the required rate of return is 10%? Which of the calculated

IRR values is correct? The answers to these questions are that they are both

mathematically correct, but they are meaningless from an economic standpoint.

Neither of these rates can be considered an adequate measure of the project's

rate of return because a project can not earn more than one rate of return over its

life. Therefore, the calculation of an IRR value(s) does not always enable the

decision-maker to make accept/reject decisions on investment proposals.

How often this problem of multiple rates actually occurs?

The possibility of multiple-rate occurrences is perhaps more prevalent in

the case of new mining ventures than in most other industries. The negative

cash flows are typically the result of anticipated periods of reduced market

prices, major capital expenditures for equipment replacement, expansion

programs, and/or major environmental expenditures, particularly at the end of

project life.

Because of the possibility of multiple rates and the reinvestment

assumption when using-the IRR to rank projects, the evaluator must carefully

consider the exclusive use of this technique for decision-making.

There is nothing so disastrous as a rational investment

policy in an irrational world John Maynard Keynes

We have discussed the time value of money and illustrated

several examples of its use. In all cases an interest rate or

discount rate is used to bring the future cash flows to the

present (NPV - Net Present Value)

The selection of the appropriate discount rate has been the

source of considerable debate and much disagreement. In

most companies, the selection of the discount rate is

determined by the accounting department or the board of

directors and the engineer just uses the number provided to

him, but short of just being provided with a rate, what is the

correct or appropriate rate to use?

Example

What is the impact of the discount rate on the investment?

Cash

Flow Yr 0

Cash

Flow Yr 1

Cash

Flow Yr 2

Cash

Flow Yr 3

Cash

Flow Yr 4

Cash

Flow Yr 5

-500

-500

+750

+600

+800

+1000

IRR

ROR

NPV

2%

1,941

6%

1,581

10%

1,283

15%

981

20%

739

47.82%

According to practice, the discount rate has to cover the following

items:

Opportunity Costs

Transaction Costs

Compensate for Risk

Cover anticipated Inflation

Some of these items can be accounted for in other financial analysis

methods and do not have to be address in the discount rate itself.

The financial cost of capital is based on the assumption

that financing is unlimited and the company can always

pay off loans or buy stock back, so the financial cost of

capital rate of return is the average cost of debt after tax

(remember interest is tax deductible) and the cost of

equity (what the share holders desired return is using the

capital asset pricing model CAPM)

The cost of capital is the minimum rate of return that a

firm needs to earn on new investments to maintain the

existing value of its shares of common stock. To

determine the cost of capital a weighted average of all

sources of capital must be evaluated. The weighted

average should include a mix of debt and equity on an

after tax basis.

Hurdle Rate

The hurdle rate is a common term used by companies

as an expression of their rate of return used for financial

analysis.

This is generally a higher number than the FCC rate as

they add an imposed economic hurdle for the project to

overcome. This helps companies express that a project

that just achieves a FCC rate of return does not add real

value to the company.

The opportunity cost of capital is the most

common method of establishing the

investors minimum rate of return.

This is based upon the expected returns that

the company will generate in the next 1 to

15 years. It is the average return that

investors expect to make over the next few

years expressed as a compound interest.

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