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CIA Abbreviations
PBP = payback period ARR = accounting rate of return
DCF methods:
NPV
cash-flow-based
IRR
cash-flow-based
(Think how much you would get in a years time if you invested 900 now.)
3. What if the prevailing rate of interest was 15%?
When looking at cash flows over a number of years, to be sure of comparing like with like, future amounts should be reduced by the prevailing interest rate. This rate is more usually known as the discount rate.
Compounding
Compounding is the effect of repeatedly adding interest earned to the lump sum invested so that interest will be paid on larger and larger amounts as time passes. *********** E.g. What is the value of 751 invested at 10% p.a. for 3 years? Year 1 Year 2 Year 3 751 1.10 = 826 826 1.10 = 909 909 1.10 = 1,000
LE 1: Compounding
If 500 is invested at 7.5% p.a. compound for 4 years, how much will it be worth at the end of the 4 years?
Solution
Discounting
Discounting can be viewed as the opposite process to compounding.
E.g. You own a machine, which will produce a cash income of 1,000 p.a. for each of the next three years. What is the present value of this income stream if the discount rate is 10% p.a.? Year 1 2 3 Cash 1,000 1,000 1,000 10% discount factor Present value x 0.9091 909 x 0.8264 826 x 0.7513 751 Total present value = 2,486
LE 2: Discounting
Discount the cash flows of the manicure parlour to the present time using a rate of 3% p.a.
Year Year Year Year Year 1 2 3 4 5 50,000 60,000 70,000 80,000 65,000
Solution
annual cash flows (adjust profits as necessary) inflows are positive, outflows are negative.
NPV Example
A vending machine costs 2,500. It will produce positive net cash inflows of 1,000 a year for each of the next 3 years (residual value = nil). What is the NPV if the discount rate is 10% p.a.? ************** Year 0 1 2 3 Cash in/out (2,500) 1,000 1,000 1,000 10% discount factors Present value 1.000 = (2,500) 0.909 = 909 0.826 = 826 0.751 = 751 NPV = (14)
x x x x
Limitations of NPV
Apart from the initial cash outlay to create the project, the cash flows for each year are assumed to occur all on the last day of the year. This is clearly unrealistic. (This is because discounting is the exact opposite of annual compounding.)
The cost of capital is assumed to remain constant over the whole lifetime of the project. This is very unlikely to be the case.
2. If your NPV is positive, repeat the process using a higher discount rate in order to give a negative NPV. (If first NPV is negative, try a lower rate.) 3. When you have one positive and one negative NPV, use interpolation to find the rate giving NPV = 0.
IRR - Interpolation
Where, A = the given Discount rate NPVA = NPV for Discount rate A
B
e.g. 10%
= Assumed Discount rate (if NPVA is a positive number use a larger Discount rate) NPVB = NPV for Discount rate B
IRR = 10% + [15035 / (15035 + 8895) (20% - 10%)] = 10% + [15035 / (23930) x (10%)] = 10% + 6.28% = 16.28% +71 0 gap = 360
Solution
Year Cash Flow Discount Rate 10% PV Discount Rate ___% PV
NPV
Limitations of IRR
Multiple rates of returns can occur when a project has unconventional cash flows It is assumed that the cash flows received from a project are re-invested at the IRR and not the cost of capital It cannot deal with different sized projects. For example, it is better to earn a return of 35% on 100,000 than 40% on 10,000.
Choice of Method
If the choice of projects is to be decided upon the results
of NPV and IRR, the NPV results are preferred over IRR. NPV has none of the flaws of IRR and returns the value in monetary terms which are more realistic than percentages. NPV values can be easily amended for risk by increasing or decreasing the discount rate. NPV calculations can accommodate changes in inflation and tax thus making the results more robust.