Lecture 9

Planning
investments –
discounted cash flow
techniques
 Concept Map
CAPITAL
BUDGETING

Net present value (NPV),

Internal rate of return
(IRR), Profitability index
rules (PI)

ACCEPT REJECT
 Learning Outcomes
• Define and identify investments.
• Identify cash flows associated with specific
investments.
• Use discounted cash flow to reduce these cash
flows to a common, present value basis.
• Calculate internal rate of return (IRR).
• Use NPV and IRR to compare investment
 Introduction
This is one of the most important chapter of
the course. Review chapter 3, “The time
value of money”, before you start. Make sure
you understand each stage of this chapter
before you go on to the next.

Investment is a fundamental activity of

business. Investment may be in:
 capital expenditure
 marketing
 product development, or
 Other companies
 Introduction
But, whatever the investment, the objective should be
wealth maximisation. To decide on the best investment,
companies need a way of comparing investments of different
values, different cash flows and different time scales. This is
provided by discounted cash flow (DCF). This chapter
introduces DCF.

The textbook addresses this topic under five headings:

 Investment and the business of the firm.

 Investments and firm value.
 Estimating cash flows.
 Net present value (NPV).
 Internal rate of return (IRR).
 Why we need to know the cost of capital?

An investment is an outlay of capital with a view of gaining future

benefits of greater value. Three such investment might be:

 buying a showroom for $400,000 expecting it to increase

revenue by $80,000 forever;
developing a new product, which will take two years and costs
$300,000, and will add $75,000 to profits for the following eight
years; and
 investing in a major marketing campaign, which will cost
$200,000 and will increase profits by $70,000 a year for the next
four years.

How do you decide which of these three projects is the best for
the company?
Four common characteristics of investment decisions
1. Relatively large initial outlay – buying a new computer is
an investment decision; buying an ink cartridge is an
operating decision. (Sometimes, operating decisions can be
larger than investment decisions, but this is unusual!
2. Relatively long horizons – You expect a computer printer to
last for three years, an ink cartridge for three months.
3. Relatively difficulty to reverse – If you choose the wrong
computer printer, you won’t have the opportunity to
change it.
4. Projects have risk – If you spend money now in the
anticipation of future benefits, there is risk. Markets could
collapse due to fashion change; competitors could appear
unexpectedly; there could be disastrous political changes.
Investment and firm value
A good investment should increase firm value immediately. If
the Board announces that an investment has been made,
which will produce a guaranteed income with a net value of
$200,000, then this should immediately increase the value of
the company by $200,000. If there are 10 million shares, the
share price should jump by 2 cents immediately.

If investors believe an investment will be profitable, then the

share price will rise. The amount the share price rises will
depend on the consensus view of the amount of profit and
the amount of risk.
Estimating cash flows

In order to calculate any investment project, you have to

identify the cash flows associated with the project. This
means not only the initial investment, but also secondary
effects such as extra working capital, and opportunity cost of
space.

Identifying relevant cash flows

When considering the cash flows associated with new
investments, we must always ask: “Is this relevant?”. A
relevant cash flow is a cash flow which would not have
occurred if this investment had not happened
Identifying relevant cash flows

Here are six examples:

1. If we install this widgeomat, we will need one new
maintenance worker. This is a cash outflow – a negative
cash flow.
2. If we buy this groungatron, we will be able to reduce our
production workers by one. This is a positive cash flow.
3. We need a maintenance worker to maintain the new
thyrator, but this will be done by one of our present
maintenance staff. No cash flow. But one job presently
done by our maintenance staff will have to be
subcontracted. This will cost us $6000 per year. This is
incurred indirectly because of the new thyrator; it is a
relevant cost – a negative cash flow.
4. The new thingalyser will occupy 3 square meters of floor
space available but is not being used now. No cash flow.
Identifying relevant cash flows

Here are six examples:

5. The betagator will occupy 3 square meters of floor space.

Currently, this is being used to re records which we never
use but which we are required by law to store. We can
warehouse these for $500 per year. Negative cash flow.
6. The new contraptomat will occupy three square meter
which otherwise could be used for a new photocopier,
which would save $1000 per year. This is an “opportunity
cost”. Negative cash flow $1,000.
 Estimating initial outlay

Often a problem will state “installed cost $10,000”. Installed

cost should include transport, import duties and cost of
documentation, installation (including any building
modification). In an engineering company, our average cost was
about 8.5% higher than the capital cost paid to the supplier.

Other initial costs which are easy to overlooked or to

underestimate are training and learning costs, any additional
marketing etc.
 Estimating net operating cash flows
This is often easier than you expect

Additional sales $100,000 per year

1 additional worker ($10,000)
His direct overhead ($2,000)
Space (opportunity cost) ($5,000)
Material for extra products ($12,000)
Sales costs of the extra products ($10,000)
Net operating cash flow $61,000 per year

The direct overheads are extra costs incurred directly because of this extra
worker and his machine.
These might include
oiling the machine,
insurance on the worker,
Extra electricity used, and
Tea bags and toilet paper for the worker.
These you have met in studying marginal cost in FACD 24 (FM1)
 Estimating net operating cash flows
Note that a share of general overheads – office worker costs, for example, is
not a cash flow, unless the general overheads genuinely increase as a result
of this extra machines and extra worker. These you have met as ‘fixed costs’.
 Estimating terminal value
When you have finished using the machine, what will you do with it?
Will you sell it? For how much?
How much will it cost for transport?
How much will it cost for repair the building afterward?
Will you have to pay someone to take it away?
Will it enable you to reduce your working capital back to its previous level?

For example Nuke Ltd operates a small nuclear plant, generating electricity
to supply the whole island of Nukealoa. The plant costs $10 million to install.
After 30 years of operations the site will be seriously radioactive. It will cost
$25 million to dispose off the plant safely, and to decontaminating the site.
The cash flow of the capital costs site.

Y0 Y30

Capex (10 mn)

Terminal Value (25mm)

 Putting it all together
Bring together all the information in tabular form, on a time line or cash flow
chart. Time should always be horizontal, and each item of cash flow should
be separate and labeled. In real life, never try to work without a cash flow
chart.
 Net Present Value (NPV)
Having drawn up the cash flow chart, apply the time discount factor to each
cash flow, and sum the total. This is the net present value (NPV). If NPV is
zero, then it means you are exactly covering your cost of capital. This
investment is neither good nor bad. If NPV is negative, you are not covering
your cost of capital. A positive NPV is good news: It can be called
“superprofit”.

Consider two examples:

1. Mynabird Curries Ltd install a new machine costing $10,000. This is
increases net earnings by $3,000 a year for 5 years, and is sold at the
end for $1,000. The cost of capital is 11%. The cash flow chart is

Y0 Y1 Y2 …….. Y5
Capex (10,000)
Earning 3,000 3,000 ……. 3,000
Final sale _______ ______ ______ 1,000
Net Cash flow (10,000) 3,000 3,000 …….. 4,000
 Net Present Value (NPV)
Consider two examples:
1. Mynabird Curries Ltd install a new machine costing $10,000. This is
increases net earnings by $3,000 a year for 5 years, and is sold at the
end for $1,000. The cost of capital is 11%. The cash flow chart is

Y0 Y1 Y2 …….. Y5
Capex (10,000)
Earning 3,000 3,000 ……. 3,000
Final sale _______ ______ ______ 1,000
Net Cash flow (10,000) 3,000 3,000 …….. 4,000

NPV at 11%
(10,000) today (10,000)
3,000 x 4 years 3,000 x 3.1024 9,307.2
4,000 @ Y5 4,000 x .5935 2374.40
NPV $1,681
This appears to be good investment
 Net Present Value (NPV)
Street Repairs Ltd bought a new machine costing $50,000. They pay $40,000
on delivery, and $10,000 one year later. It requires $10,000 of overhaul at
the end of year 3, and is sold for $2,000 at the end of year 5. It increases
net earnings by $20,000 a year for first three years, and $10,000 a year for
the last two years. Cost of capital is 9%

First draw your cash flow chart.

Y0 Y1 Y2 Y3 Y4 Y5
Capex (40) (10)
Earnings 20 20 20 10 10
Overhaul (10)
Final sale 2 __________
Nets cash flow (40) 10 20 10 10 12
Discount factor 1 .917 .841 .772 .708 .649 Total
PV of cash flow (40) 9.17 16.834 7.722 7.084 7.799 8.613

Total NPV of project = $8,613, this appears to be good investment

Internal rate of return (IRR)
“This is a good purchase at our present cost of capital of 9%. But we all
know that the cost of capital will rise because of bad government
spending decisions. Will it be good purchase decisions at 11%? What is
the breakeven point?

The discount rate at which NPV is exactly zero. The cost of capital at
which the project exactly breaks even. It id called the internal rate of
return, IRR. This is an important number.

It is possible to have two projects with the same NPV at a cost of capital
of 9%, but one project would have a negative NPV at 14%, the other
positive. The first project is more sensitive to interest rate risk. The IRR
figure will tell how much the cost of capital will have to increase, before
the project becomes unprofitable.
 Calculating IRR
You find IRR by trial and error procedure as follows:

1. Take the first “cost of capital “ or “discount rate” you are given, or if you
are not given one start with 10%. Calculate NPV.
2. If NPV is negative take half the initial discount rate and calculate NPV
again.
3. If NPV is positive, add 10% to the discount rate, and calculate NPV gain.
4. Repeat process (2) or (3) until you have both a positive and a negative
NPV figure
5. Take an average using the following equation

IRR = I1 + (I2 – I1) * NPV1

(NPV1 – NPV2)

Where I1 is the interest rate of the positive NPV

I2 is the interest rate of the negative NPV
NPV1 is the positive NPV
NPV2 is the negative NPV
Calculating IRR
Learn this formula. It is the fourth (and last) important formula in
corporate finance which I require you to know. In this course, I expect
you to learn and to know how to use, four formulae. This is the FOURTH!

Remember “minus a minus number” makes a plus. So, if NPV2 is

negative, then you add the two figures together!
 Calculating IRR
Example
Find the IRR of the following cash flow, assuming a cost of capital of 9%

Y0 Y1 Y2 Y3
(100) 10 50 80

Answer (start with 9% and then 19%)

NPV at 9% NPV at 19% NPV at 15%
(100) (100) (100) (100)
10 at Y1 10*.9174 9.174 8.403 8.696
50 at Y2 50*.8417 42.085 35.31 37.805
80 at Y3 80*.7722 61.776 47.472 52.5

NPV 13.035 (8.815) (0.9)

 Calculating IRR
Example
See below why I chose 15%

I1 = 9% I2 = 19%

NPV1 = 13.035 NPV2 = -8.815

IRR = I1 + (I2 - I1) * NPV1

(NPV1 – NPV2

= 9 + (10)*(13.035) = 9 + 5.96 =± 15%

(13.035 + 8.815)

The fist estimate of IRR is 15%.

 Summary
Here are the important points discussed in this unit:
 Investment projects are evaluated and compared using discounted cash
flow (DCF) methods to determine net present value (NPV)
 All relevant cash flows, including marginal changes in overheads and
including opportunity costs, must be identified and included.
 Allocated costs (e.g. a share of fixed overheads) are not cash flows and
should not be included.
 All cash flows should be discounted at the rate used for investment
appraisal.
 A positive NPV is a “super-profit” above the cost of capital. To be more
precise the NPV is the present value of the future profits generated by
the project. Theoretically it measures the changes of the firm value now.
 The internal rate of return (IRR) is the discount rate at which NPV is
exactly zero. This is a measure of the sensitivity of the project to a
change in interest rates.
END OF LECTURE

HAVE A NICE DAY