F9FM-Session04 d08jnkn

SESSION 04 DISCOUNTED CASH FLOW TECHNIQUES
0401
OVERVIEW
Objective
To apply the time value of money to investment decisions.

INTEREST
DISCOUNTING SIMPLE
INTERNAL RATE
OF RETURN (IRR)
Single sum
Annuities
Effective Annual Interest Rates
(EAIR)
Procedure
Meaning
Cash budget pro forma
Tabular layout
Annuities
Perpetuities
DISCOUNTED
CASH FLOW (DCF)
TECHNIQUES
COMPOUND
NET PRESENT
VALUE (NPV)
Compounding in
reverse
Points to note
Time value of money
DCF techniques
Definition and decision
rule
Perpetuities
Annuities
Uneven cash flows
Unconventional cash
flows
NPV vs. IRR
Comparison

0402
1 SIMPLE INTEREST
Interest accrues only on the initial amount invested.
Illustration 1

If $100 is invested at 10% per annum (pa) simple interest:
Year Amount on deposit Interest Amount on deposit
(year beginning) (year end)
1 $100 0.1 100 = 10 $110
2 $110 0.1 100 = 10 $120
3 $120 0.1 100 = 10 $130

A single principal sum, P invested for n years at an annual rate of interest, r (as a
decimal) will amount to a future value FV.
Where FV = P (1 + nr)
2 COMPOUND INTEREST
Interest is reinvested alongside the principal.
2.1 Single sum
Illustration 2

If Zarosa placed $100 in the bank today (t
0
) earning 10% interest per annum,
what would this sum amount to in three years time?

Solution
In 1 years time, $100 would have increased by 10% to $110
In 2 years time, $110 would have grown by 10% to $121
In 3 years time, $121 would have grown by 10% to $133.10

Or

FV = P (1 + r)
n

where
P = initial principal
r = annual rate of interest (as a decimal)
n = number of years for which the principal is invested

0403

Example 1

$500 is invested in a fund on 1.1.X1. Calculate the amount on deposit by
31.12.X4 if the interest rate is
(a) 7% per annum simple
(b) 7% per annum compound.

Solution
The $500 is invested for a total of 4 years
(a) Simple interest FV = P (1 + nr)
FV =
(b) Compound interest FV = P (1 + r)
n

FV =

Example 2

$1,000 is invested in a fund earning 5% per annum on 1.1.X0. $500 is added to
this fund on 1.1.X1 and a further $700 is added on 1.1.X2. How much will be
on deposit by 31.12.X2?

Solution
Date Amount
invested
Compound
interest factor
= Compounded
cashflow
$ $

1.1.X0 1,000
1.1.X1 500
1.1.X2 700

_________
Amount on deposit =

_________

0404
2.2 Annuities
Many saving schemes involve the same amount being invested annually.
There are two formulae for the future value of an annuity. Which to use depends on
whether the investment is made at the end of each year or at the start of each year.

(i) first sum paid/received at the end of each year
(ii) first sum paid/received at the beginning of each year

(i) FV =
( )
|
|
.
|
\
| +
r
r
n
1 1
a (ii) FV =
( )
|
|
.
|
\
|
|
|
.
|
\
| +
+
1
1 1

1
r
r
n
a

where a = annuity (i.e. annual sum)
r = interest rate (interest payable annually in arrears)
n = number of years annuity is paid/invested

Commentary

These formula will not be provided in the examination

Illustration 3

Andrew invests $3,000 at the start of each year in a high interest account
offering 7% pa. How much will he have to spend after a fixed 5 year term?

Solution
FV = $3,000
( )
|
|
.
|
\
|
|
|
.
|
\
|
1
07 . 0
1 07 . 1
6
= $3,000 6.153 = $18,460
2.3 Effective Annual Interest Rates (EAIR)
Where interest is charged on a non-annual basis it is useful to know the effective annual
rate.
Foe example interest on bank overdrafts (and credit cards) is often charged on a
monthly basis. To compare the cost of finance to other sources it is necessary to know
the EAIR.
Formula
1 + R = (1 + r)
n

R = annual rate
r = rate per period (month/quarter)
n = number of periods in year
0405

Illustration 4

Borrow $100 at a cost of 2% per month. How much (principal + interest) will
be owed after a year?
Using FV = P (1 + r)
n
= 100 (1.02)
12

= 100 1.2682 * = 126.82

EAIR is 26.82%

3 DISCOUNTING
3.1 Compounding in reverse
Discounting calculates the sum which must be invested now (at a fixed interest rate) in
order to receive a given sum in the future.
Illustration 5

If Zarosa needed to receive $251.94 in three years time (t
3
), what sum would
she have to invest today (t
0
) at an interest rate of 8% per annum?

Solution
The formula for compounding is:
FV = P (1 + r)
n

Rearranging this:
P = FV
1
1 ( ) + r
n

or alternatively PV = CF
1
1 ( ) + r
n

where PV = the present value of a future cash flow (CF)
r = annual rate of interest/discount rate.
n = number of years before the cash flow arises

In this case PV = $251.94
3
(1.08)
1
= $200
The present value of $251.94 receivable in three years time is $200.
0406
3.2 Points to note

n
r) 1 (
1
+
is known as the simple discount factor and gives the present value of $1
receivable in n years at a discount rate, r.

A present value table is provided in the exam
The formula for simple discount factors is provided at the top of the present value
table.

For a cash flow arising now (at t
0
) the discount factor will always be 1.
t
1
is defined as a point in time exactly one year after t
0
.
Always assume that cash flows arise at the end of the year to which they relate (unless
told otherwise).

Example 3

Find the present value of
(a) 250 received or paid in 5 years time, r = 6% pa
(b) 30,000 received or paid in 15 years time, r = 9% pa.

Solution
(a) From the tables: r = 6%, n = 5, discount factor =
Present value =
(b) From the tables: r = 9%, n = 15, discount factor =
Present value =
0407
4 DISCOUNTED CASH FLOW (DCF) TECHNIQUES
4.1 Time value of money
Investors prefer to receive $1 today rather than $1 in one year.
This concept is referred to as the time value of money
There are several possible causes:
Liquidity preference if money is received today it can either be spent or
reinvested to earn more in future. Hence investors have a preference for having
cash/liquidity today.
Risk cash received today is safe, future cash receipts may be uncertain.
Inflation cash today can be spent at todays prices but the value of future cash
flows may be eroded by inflation

DCF techniques take account of the time value of money by restating each
future cash flow in terms of its equivalent value today.

4.2 DCF techniques
DCF techniques can be used to evaluate business projects i.e. for investment appraisal.
Two methods are available:
NET PRESENT
VALUE

INTERNAL RATE
OF RETURN

0408
5 NET PRESENT VALUE (NPV)
5.1 Procedure
Forecast the relevant cash flows from the project
Estimate the required return of investors i.e. the discount rate. The required return of
investors represents the companys cost of finance, also referred to as its cost of capital.
Discount each cash flow (receipt or payment) to its present value (PV).
Sum present values to give the NPV of the project.
If NPV is positive then accept the project as it provides a higher return than required by
investors.
5.2 Meaning
NPV shows the theoretical change in the $ value of the company due to the project.
It therefore shows the change in shareholders wealth due to the project.
The assumed key objective of financial management is to maximise shareholder wealth.
Therefore NPV must be considered the key technique in business decision making.
5.3 Cash budget pro forma
Time 0 1 2 3
$000 $000 $000 $000
Capital expenditure (X) X
Cash from sales X X X
Materials (X) (X) (X)
Labour (X) (X) (X)
Overheads (X) (X) (X)
Advertising (X) (X)
Grant X
___ ___ ___ ___
Net cash flow (X) X X X
___ ___ ___ ___
r% discount factor 1
1
1 + r

1
1
2
( ) + r

1
1
3
( ) + r

Present value (X) X X X

NPV = X
0409
5.4 Tabular layout
Discount Present
Time Cash flow factor value
$000 @ r% $000
0 CAPEX (X) 1 (X)
110 Cash from sales X x X
09 Materials (X) x (X)
110 Labour and overheads (X) x (X)
0 Advertising (X) x (X)
2 Advertising (X) x (X)
1 Grant X x X
10 Scrap value X x X
___
Net present value X
___

Example 4

Elgar has $10,000 to invest for a five-year period. He could deposit it in a bank
earning 8% pa compound interest.
He has been offered an alternative: investment in a low-risk project that is
expected to produce net cash inflows of $3,000 for each of the first three years,
$5,000 in the fourth year and $1,000 in the fifth.
Required:
Calculate the net present value of the project.

Solution
Time Description Cash flow 8% DF PV
$ $
0 Investment (10,000)
1 Net inflow 3,000
2 Net inflow 3,000
3 Net inflow 3,000
4 Net inflow 5,000
5 Net inflow 1,000
_____
NPV =
_____

0410
5.5 Annuities
An annuity is a stream of identical cash flows arising each year for a finite period of
time.
The present value of an annuity is given as
CF
(
(
n
r) + (1
1
1
r
1

where CF is the cash flow received each year commencing at t
1
.

(
(
n
r) + (1
1
1
r
1
is known as the annuity factor or cumulative discount factor. It is
simply the sum of a geometric progression.
The formula is given in the exam as
1 - (1+ r)
r
n

Annuity factor tables are also provided in the exam
Remember that the formula and tables are based on the assumption that the cash flow
starts after one year.
Illustration 6

Calculate the present value of $1,000 receivable each year for 3 years if interest
rates are 10%.
Time Description Cash flow 10% Annuity factor PV
$ $
t13 Annuity 1,000
(

3
1.1
1
1
0.1
1
= 2.486 2,486

Note: An annuity received for the next three years is written as t
13
.

Example 5

Calculate the present value of $2,000 receivable for each of 10 years
commencing three years from now. Assume interest at 7%.

0411
Solution

5.6 Perpetuities
A perpetuity is a stream of identical cash flows arising each year to infinity.
As n
(1 + r)
n

0
r) + (1
1
n

r
1
) r 1 (
1
1
r
1
n

|
|
.
|
\
|
+

r
1
is known as the perpetuity factor.
The present value of a perpetuity is given as CF
r
1

where CF is the cash flow received each year.
The formula is based on the assumption that the cash flow starts after one year.
Illustration 7

Calculate the present value of $1,000 receivable each year in perpetuity if
interest rates are 10%.

Solution
$ $
t
1
Perpetuity 1,000
1
01 .
= 10
10,000

0412

Example 6

Calculate the present value of $2,000 receivable in perpetuity commencing in
10 years time. Assume interest at 7%.

Solution

6 INTERNAL RATE OF RETURN (IRR)
6.1 Definition and decision rule
IRR is the discount rate where NPV = 0
IRR represents the average annual % return from a project.
It therefore shows the highest finance cost that can be accepted for the project.

If IRR > cost of capital, accept project.
If IRR < cost of capital, reject project.
6.2 Perpetuities
If a project has equal annual cash flows receivable in perpetuity then
IRR =
investment Initial
inflows cash Annual
100%
Illustration 8

An investment of $1,000 gives income of $140 per annum indefinitely, the
return on the investment is given by
IRR = 140/1000 100% = 14%

0413

Example 7

An investment of $15,000 now will provide $2,400 each year to perpetuity.
Required:
Calculate the return inherent in the investment.

Solution

6.3 Annuities
To give an NPV of zero, the present value of the cash inflows must equal the initial cash
outflow.
i.e. annual ash inflow Annuity factor = Cash outflow
Annuity factor =
inflow Cash
outflow Cash

Once the annuity factor is known the discount rate can be established from the
appropriate table.
Illustration 9

An investment of $6,340 will yield an income of $2,000 for four years.
Calculate the internal rate of return of the investment.

Solution
Year Description CF DF PV
0 Initial investment (6,340) 1 (6,340)
1-4 Annuity 2,000 AF
1-4
years

6,340
_____
NPV Nil
_____
AF
1-4
years =
000 , 2
340 , 6
= 3.17
From the annuity table, the rate with a four year annuity factor closest to 3.17 is 10% and this
is therefore the approximate IRR for this investment.
0414
Example 8

An immediate investment of $10,000 will give an annuity of $1,000 for the next
15 years.
Required:
Calculate the internal rate of return of the investment.

Solution
Time Description Cash flow Discount factor PV
$ $
0 Investment (10,000)
1-15 Annuity 1,000
______

______

6.4 Uneven cash flows
Method
Calculate the NPV of the project at a chosen discount rate.
If NPV is positive, recalculate NPV at a higher discount rate (i.e. to get closer to IRR).
If NPV is negative, recalculate at a lower discount rate.
The IRR can be estimated using the formula:
A) (B
N N
N
A ~ IRR
B A
A
+

Where A = Lower discount rate
B = Higher discount rate
N
A
= NPV at rate A
N
B
= NPV at rate B

This method is known as linear interpolation.
0415

Illustration 10

The NPVs of a project with uneven cash flows are as follows.
Discount rate NPV

10% 64,237
20% (5,213)

Estimate the IRR of the investment.

Solution
IRR ~ A +
B A
A
N N
N
(B A)

IRR ~ 10% +
) 213 , 5 ( 237 , 64
237 , 64

(20 10)%
IRR ~ 19%

Graphically
NPV
Discount rate
IRR using formula
(interpolated)
B A
Actual IRR
N
A
N
B Actual NPV as
discount rate varies

0416

Example 9

An investment opportunity with uneven cash flows has the following net
present values
$
At 10% 71,530
At 15% 4,370

Required:
Estimate the IRR of the investment.

Solution
Formula
IRR ~ A +
B A
A
N N
N
(B A)
IRR ~

Graphically

0417
6.5 Unconventional cash flows
If there are cash outflows, followed by inflows are then more outflows (e.g. suppose at the
end of the project a site had to be decontaminated), the situation of multiple yields
may arise i.e. more than one IRR.
NPV
Discount rate IRR1
Actual IRR
Actual NPV as
discount rate varies
IRR2

The project appears to have two different IRRs in this case IRR is not a reliable
method of decision making.
However NPV is reliable, even for unconventional projects.
7 NPV vs. IRR
7.1 Comparison
NPV IRR
An absolute measure ($) A relative measure (%)
If NPV 0 ,accept If IRR target %, accept
If NPV 0, reject
Shows $ change in value of
company/wealth of shareholders
A unique solution i.e. a project has only
one NPV
Always reliable for decision making
If IRR target %, reject
Does not show absolute change in
wealth
May be a multiple solution

Not always reliable

0418

Key points

Discounted cash flow techniques are arguably the most important
methods used in financial management.
DCF techniques have two major advantages (i) they focus on cash flow,
which is more relevant than the accounting concept of profit (ii) they take
into account the time value of money.
NPV must be considered a superior decision-making technique to IRR as it
is an absolute measure which tells management the change in
shareholders wealth expected from a project.

FOCUS
You should now be able to:

explain the difference between simple and compound interest rate and
calculate future values;
calculate future values including the application of annuity formulae;
calculate effective interest rates;
explain what is meant by discounting and calculate present values;
apply discounting principles to calculate the net present value of an investment project
and interpret the results;
calculate present values including the application of annuity and perpetuity formulae;
explain what is meant by, and estimate the internal rate of return, using a graphical and
interpolation approach, and interpret the results;
identify and discuss the situation where there is conflict between these two methods of
investment appraisal;
compare NPV and IRR as decision making tools.
0419
EXAMPLE SOLUTION
Solution 1 7% simple and compound interest
The $500 is invested for a total of 4 years
(a) Simple interest FV = P (1 + nr)
FV = 500 (1 + 4 0.07) = 500 1.28 = $640
(b) Compound interest FV = P (1 + r)
n

FV = 500 (1 + 0.07)
4
= 500 1.3108 = $655.40

Solution 2 5% compound interest
Date Amount Compound Compounded
invested interest factor = cashflow
$ $

1.1.X0 1,000 (1 + 0.05)
3
1,157.63
1.1.X1 500 (1 + 0.05)
2
551.25
1.1.X2 700 (1 + 0.05)
1
735.00

_________
Amount on deposit = 2,443.88

_________

Solution 3 Present value
(a) From the tables: r = 6%, n = 5, discount factor = 0.747
Present value = 250 0.747 = $186.75
(b) From the tables: r = 9%, n = 15, discount factor = 0.275
Present value = 30,000 0.275 = $8,250
0420
Solution 4 Net present value
Time Description Cash flow 8% DF PV
$ $
0 Investment (10,000) 1 (10,000)
1 Net inflow 3,000
) 08 . 1 (
1

2,778
2 Net inflow 3,000
2
) 08 . 1 (
1

2,572
3 Net inflow 3,000
3
) 08 . 1 (
1

2,381
4 Net inflow 5,000
4
) 08 . 1 (
1

3,675
5 Net inflow 1,000
5
) 08 . 1 (
1

681
_____
NPV = 2,087
_____

Solution 5 Annuity
$ $
t
3-12
Annuity 2,000 6.135 (W) 12,270
WORKING
Cdf
3-12
@ 7% = CDF
1-12
@ 7% CDF
1-2
@ 7%
= 7.943 1.808 (per tables)
= 6.135

Solution 6 Perpetuity
$ $
t
10-
Perpetuity 2,000 7.771 (W) 15,542

0421
WORKING
Cdf
10-
@ 7% = CDF
1-
@ 7% - CDF
1-9
@ 7%
=
07 . 0
1
6.515 (per tables)
= 14.286 6.515
= 7.771

Solution 7 IRR (perpetuity)
IRR =
000 , 15
400 , 2
100 = 16%
Solution 8 IRR (annuity)
Time Description Cash flow Discount factor PV
$ $
0 Investment (10,000) 1 (10,000)
1-15 Annuity 1,000 Cdf
1-15
= 10 (al) 10,000
______
Nil
______
From the annuity table the rate with a 15 year annuity factor of 10 lies between 5% and 6%.
Thus if $10,000 could be otherwise invested for a return of 6% or more, this annuity is not
worthwhile.
Solution 9 IRR (uneven cash flows)
Formula
Commentary

The formula always works but take care with + and signs.
IRR ~ A +
B A
A
N N
N
(B A)
IRR ~ 10 + |
.
|
\
|
370 , 4 530 , 71
530 , 71
(15 10)
IRR ~ 10 + 5.325
say 15.4% (rounded up)
0422
Graphically
4,370
71,530
10 15
NPV
Discount rate
(%)
Actual
IRR
IRR using
formula
(extrapolated)
Actual
NPV

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SESSION 04 DISCOUNTED CASH FLOW TECHNIQUES

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