Chapter 5 Discounted cash flow techniques

Net present value

Only

include relevant / incremental cash flows in the

NPV calculations:

Future amounts (cash flows that arise as a consequence of

the decision) ignore all sunk costs
Cash flows only ignore all non-cash flows. e.g. depreciation
Directly relevant ignore all overheads in existence prior to
the decision (would be incurred with or without the project)
Ignore interest payments and their tax effects as implicit in the
discount rate
Include opportunity costs costs incurred or revenues lost
from diverting existing resources from their existing use for
example overseas investment might have impact on existing
exports (lost contribution is relevant cost of investment)

NPV

Corp tax on profits

-

Capital allowances
-

tax payments (benefit) on operating profit (losses)

tax saved on capital allowances
Can be calculated together but recommended to show 2 cash
flows separately effect of taxation not necessary in the same
period as the relevant cash flow that causes it
follow the instruction given in the exam question
in the exam questions usually 25% writing down allowances on
plant & machinery
dont forget about balancing adjustment in the year the asset is
sold
check carefully the instruction given in the question examiner
could possibly use 100% first year allowances, straight line
method

Working capital
-

the relevant cash flows are the incremental cash flows from one years
requirements to the next. At the end of project the full amount invested
will be released

NPV layout
A neat layout will gain credibility in the exam and will help you make
sense of the many different cash flows that you will have to deal with.
Time
0

Salesreceipts

Costs

(X)

(X)

(X)

(X)

Saleslesscosts

Taxation

(X)

(X)

(X)

(X)

Capitalexpenditure

(X)

(X)

Scrapvalue

TaxbenefitofCAs

Workingcapital

(X)

(X)

(X)

(X)

Netcashflows

(X)

Discountfactors@

(X)

post-taxcostofcapital*
Presentvalue

Net present value

Inflation
Key terms
Real terms or current prices

Explanation
Ignoringinflation

Nominal or money

Includinginflation

InflationhastwoimpactsonNPV:
Time
0 1onwards
Cash flow

Cash inflows will increase, making the

project more attractive

Discountfactor

The cost of capital will increase, making the

project less attractive

Present value

The net impact on the NPV may be minimal

The effect of inflation

Ignore inflation if
If there is one rate of inflation, inflation
has no impact on the NPV of a domestic
investment. In this case it is normally
quicker to ignore inflation in the cash
flows (ie real cash flows) and to use an
uninflated (real) cost of capital

The effect of inflation

Include inflation if

If there is more than one rate of inflation,

inflation will have an impact on profit margins
and therefore the cash flows must be inflated
and inflation must also be incorporated into
the cost of capital.
To incorporate inflation into the cost of capital
the following equation must be used:
[1 + real cost of capital] x [1 + general inflation
rate] = [1 + inflated cost of capital]
or
(1 + r) (1 + h) = (1 + i)

The effect of inflation

Question: Effect of inflation (p.156-157)

Rice is considering a project which would cost
$5,000 now. The annual benefits, for four years,
would be a fixed income of $2,500 a year, plus
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 7.5% and the company's required money rate
of return is 16%. Is the project worthwhile?
(Ignore taxation)

Allowing for taxation

Corporation

tax on profits

Projects will cause tax to be paid on the profits,

net of tax saved on capital allowances. Tax
cash flows can be calculated as one figure, but
we recommend that two cash flows are shown:

Allowing for taxation

Corporation

tax on profits

Calculate

the taxable profits (before capital

allowances) and calculate tax at the rate given.

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).

The

effect of taxation: Follow the instructions given in

the exam question.

(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 projects increases taxable
profit 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.

Allowing for taxation

Capital allowances/Tax-allowable depreciation

Approach
1.Calculate

the amount of capital allowance claimed in

each year.

These are normally 25% writing down allowances on plant &

machinery.

2.Make

sure that you remember the balancing

adjustment in the year the asset is sold.

A taxable profit if the sale price exceeds the reducing balance,

A tax-allowable loss if the reducing balance exceeds the sale
price

3.Calculate

the tax saved, noting the timing of tax

payments given in the question.

Allowing for taxation

Assumptions about the time when taxallowable depreciation start to be claimed
It

can be assumed that the first claim occurs at

the start of the project (at year 0)
Alternatively it can be assumed that the first claim
occurs later in the first year.

Allowing for taxation

1.3.2

Example: taxation (p.158-159)

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 reducing balance 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?

Allowing for taxation

Taxation
When

and DCF

taxation is ignored in the DCF

calculations, the discount rate will reflect
the pre-tax rate of return required on
capital investments.
When taxation is included in the cash
flows, a post-tax rate of return should be
used.
Question: Effect of taxation (p.160) (home
reading)

Tax exhaustion
Capital

allowances

First year allowances

Writing down allowances
After tax earnings = Earnings

before tax Tax

liability
Tax liability = tax rate (Earnings before tax capital allowance)
When capital allowance in a particular year
equals or exceeds before tax earnings, the
company will pay no tax.
In most tax systems unused capital allowance
can be carried forward indefinitely.
Question: Capital allowance (p.162)

Net present value

Working capital
Projects need funds to finance the level
of working capital required (normally
assumed to be stock). The relevant cash
flows are the incremental cash flows
from one years requirement to the next.
These are cash flows in your schedule,
but they have no tax effects.
Unless told otherwise, you assume that
the total cash paid out is received back
at the end of the project.

Capital rationing

Capital rationing problem exist when there are insufficient

funds available to finance all available profitable projects
two main reasons:

Divisible and non-divisible projects

Single period capital rationing with divisible projects

Profitability index = NPV of project/ Initial cash outflow

Single period capital rationing with non-divisible projects

internal factors (soft capital rationing )

external factors (hard capital rationing )

Use trial and error and test the NPV available for different
combinations of projects

Practical methods of dealing with capital rationing

Seek joint venture partners

Licensing or franchising agreement
Contract out parts of a project
Seek new alternative sources of capital

Capital rationing

Multiple period capital rationing

linear programming techniques must be

applied to find the optimal combination of
divisible or indivisible projects to invest in
(define the unknowns, formulate the objective
function, express the constraints in terms of
inequalities including non-negatives)
1.5.2 An example (p.163-164)

Risk and uncertainty

Before deciding to spend money on a project, managers will want to be able to
make a judgment on its risk (predictable) and uncertainty (not predictable).
Risk

Techniques
Expected values

Description
UsingprobabilitiestocalculateaverageexpectedNPV.

Risk adjusted
discount factor

Usingahighercostofcapitaliftheprojectishighrisk,
thisisdiscussedinthenextchapter.

Risk and uncertainty

Uncertainty

Techniques

Description

Payback period

Thequickerthepaybackthelessreliantaprojectisonthelater,
moreuncertain,cashflows.

Discounted payback Asabovebutusesthediscountedcashflowsandisabetter

period
methodsinceitadjustsfortimevalue.
Sensitivity analysis

Ananalysisofwhat%changeinonevariable(egsales)would
beneededfortheNPVofaprojecttofalltozero.
CalculatedasNPVofproject/PVofsales(forexample)

Project duration

Ameasureofhowlongittakestorecoverapproximately half of
the value of the investment;itiscalculatedbyweightingeach
yearoftheprojectbythe%ofthepresentvalueofthecash
inflowsrecoveredinthatyear.

Simulation

Ananalysisofhowchangesinmorethan1parameters(eg
growthrateorcostofcapital)orvariablemayaffecttheNPVofa
project.

Risk and uncertainty

1.6.2

Example sensitivity analysis (p.166)

Nevers Ure 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 ($)

(7000)

2,000

6,000

2,500

7,000

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

Risk and uncertainty

Project

duration

Question: Project duration (p.167)

Monty Inc is considering a project which requires an initial
investment of $100,000. Projected cash flows discounted at
Montys cost of capital of 10% are as follows.
Year
Present value

(100,000
)

45,455

36,346

26,296

13,660

6,209

Calculate the project duration.

Risk and uncertainty

Monte

Carlo method

Assumes that the uncertain parameters (such as the

growth rate or the cost of capital k) or variables (such as
the free cash flow) follow a specific probability distribution.
Generate though simulation thousands of values for the
parameters or variables of interest and use those
variables to derive the net present value for each possible
simulated outcomes.
From the resulting values we can derive the distribution of
the NPV.

Project value at risk

Value

at Risk (VAR) is the minimum amount by which the

value of an investment or portfolio will fall over a given period
of time at a given level of probability.
Alternatively it is defined as the maximum amount that it may
lose at a given level of confidence.
For example we may say that the Value at Risk is $100,000
at 5 percent probability, or that it is $100,000 at 95 percent
confidence level. The first definition implies that there is a 5
percent chance that the loss will exceed $100,000, or that we
are 95 percent sure that it will not exceed $100,000. VAR can
be defined at any level of probability or confidence, but the
most common probability levels are 1,5 and 10 percent.

Value at risk
Normal
distribution

losses
24

gains

Value at risk
Normal
distribution

Max loss, with only 5%

chance of being exceeded

5%

45%
1.645 std dev

losses
25

50%
0

gains

Project value at risk

A formal

definition of the VAR of a position where the value of

the position is denoted by V is the value V* such that values
of V less than V* have a chance of only p to appear. Formally
this can be written as Probability (V < V*) =p and is shown
below. The probability level is the area under the curve and it
can be calculated as the value of the random variable that
determines the desired area under the curve.

Project value at risk

When

the random variable follows the normal distribution, the

value at risk at specific probability levels is easily calculated
as a multiple of the standard deviation. For example the 5
percent VAR is simply 1.645 , the 1 percent VAR is 2.33.

VAR

over more than one period

is determined by the probability level

is the standard deviation

is the periods over which we want to calculate the

value at risk

2.2.1

Example (p.170)

Internal rate of return (IRR)

Internal rate of return

a discounted cash flow technique of a project that calculates the %
return given by a project; accept the project if the IRR is > the cost
of capital.

Three step approach

Step 1 calculate the NPV of the project at lower of the two rates
of return used
Step 2 calculate the project at higher of the two rates of return
used
Step 3 calculate the internal rate of return using the formula

Formula

NPVa

IRR = a + NPVa-NPV b (b-a)

3.1 Example of IRR calculation (p.171-172)

3.2 The multiple IRR problem (p.172)

Comparison of NPV and IRR

4.1 Limitations of the IRR technique

4.2 Mutually exclusive projects
4.3 Reasons why the NPV profiles differ
4.4 Conflicting rankings using the NPV and
IRR methods

Re-investment rate

4.5 Other factors

Modified internal rate of return (MIRR)

IRR assumes that the cash flows after the

investment phase (here time 0) are
reinvested at the projects IRR.
A better assumption is that the funds are
reinvested at the investors minimum
required return (WACC).

Modified internal rate of return (MIRR)

In the formula below the return phase is the phase of the

project from when cash inflows have commenced.
n

PV return phase
1 i 1
PV investment phase

Where
The

return phase is the phase of the project with cash inflows

The investment phase is the phase of the project with cash
outflows
i = cost of capital

Modified internal rate of return (MIRR)

5.1 Example of MIRR calculations (p.176)

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%.
Required:
Calculate MIRR.

Modified internal rate of return (MIRR)

Alternative method
Ter min al value of return phase
MIRR
1
PV of investment phase
n

Where

The return phase is the phase of the project with cash inflows
(assuming cash flows are reinvested at the firms cost of
capital)
The investment phase is the phase of the project with cash
outflows

Use

this method to calculate MIRR of Example 5.1

Modified internal rate of return (MIRR)

Advantages of MIRR

Using the formula, MIRR is quicker to calculate than IRR, it

makes a more realistic assumption about the
reinvestment rate.
Does not give the multiple answers that can sometimes
arise with the conventional IRR.
The extent to which the MIRR exceeds the cost of capital is
called the return margin and indicates the extent to which a
new project is generating competitive advantage.

Disadvantages of MIRR
MIRR, like all rate of return methods, suffer from the
problem that it may lead an investor for reject a project which
has a lower rate of return but, because of its size, generates
a larger increase in wealth.
In the same way, a high-return project with a short life may
be preferred over a lower-return project with a longer life.