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COMPARATIVE ANALYSIS

OF DCF AND NON DCF


TECHNIQUES


Presented to : Dr. Paresh Shah


Presented by:
Sonal Nagpal (23)
Nikita Porwal (27)
Bhawana Pokharna (36)
Priyanka Chaturvedi (38)


CAPITAL BUDGETING DECISIONS
Should we
build this
plant?
CAPITAL BUDGETING DECISIONS
The investment decisions of a firm are generally
known as the capital budgeting, or capital
expenditure decisions.

The firms investment decisions would generally
include expansion, acquisition, modernisation and
replacement of the long-term assets. Sale of a
division or business (divestment) is also an
investment decision.

Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a
research and development programme have long-
term implications for the firms expenditures and
benefits, and therefore, they should also be evaluated
as investment decisions.

TYPES OF INVESTMENT DECISIONS
One classification is as follows:
Expansion of existing business
Expansion of new business
Replacement and modernisation
Yet another useful way to classify investments is as
follows:
Mutually exclusive investments
Independent investments

AN EXAMPLE OF MUTUALLY EXCLUSIVE
PROJECTS
BRIDGE vs. BOAT to get
products across a river.

CAPITAL BUDGETING DECISIONS
These are generally:

Long-term decisions; involving large
expenditures.

Have long term consequences.

Difficult or expensive to reverse.
Capital Budgeting
Methods
Discounting Criteria
NPV IRR PBP ARR
Non Discounting Criteria
NET PRESENT VALUE
NPV of a project is the sum of the present values of
all the cash flows positive as well as negative that
are expected to occur over the life of the project.
The formula for NPV is:

3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
C C C C
C
k k k k
C
C
k
=
(
= + + + +
(
+ + + +

=
+

NET PRESENT VALUE



Where,
C
t
= cash flow at the end of year t
n = Life of the project
k = discount rate (given by the projects opportunity
cost of capital which is equal to the required rate of
return expected by investors on investments of
equivalent risk).
C
0
= Initial investment
1 / (1 + k )
t
= known as discounting factor or PVIF
i.e present value interest factor.
CALCULATING NET PRESENT
VALUE
Assume that Project X costs Rs 2,500 now and is
expected to generate year-end cash inflows of Rs
900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1
through 5. The opportunity cost of the capital may be
assumed to be 10 per cent.

2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500
NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs 500(PVF
(
= + + + +
(

=
10
)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225

=

=
ACCEPTANCE RULE OF NPV
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May accept or reject the project when NPV is zero
NPV = 0
( A project will have NPV = 0, only when the project generates
cash inflows at a rate just equal to the opportunity cost of
capital)
The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.

ADVANTAGES OF NPV METHOD
It considers time value of money.
It is a true measure of profitability as it uses the present
values of all cash flows (both outflows & inflows) &
opportunity cost as discount rate rather than any other
arbitrary assumption or subjective consideration.
The NPVs of individual projects can be simply added to
calculate the value of the firm . This is known as
Principle of value additivity.
It is consistent with the shareholders wealth
maximization principle as whenever a project with
positive NPV is undertaken, it results in positive cash
flows and hence the increase in the value of the firm.

DISADVANTAGES OF NPV METHOD
It is difficult to estimate the expected cash flows
from a project.
Discount rate to be used is very difficult to
determine.
Since this method does not consider the life of the
projects, in case of mutually exclusive projects with
different life, the NPV rule, tends to be biased in
favour of the longer term project.
Since NPV is expressed in absolute terms rather
than relative terms it does not consider the scale of
investment.

Profitability Index
An index that attempts to identify the
relationship between the costs and benefits of
a proposed project through the use of a ratio
calculated as:

PI = Net Present Value * 100
Cost of Asset
Asset with the highest PI is selected.

Acceptance rule
A ratio of 1.0 is logically the lowest acceptable
measure on the index.
Any value lower than 1.0 would indicate that
the project's PV is less than the initial
investment.
As values on the profitability index increase,
so does the financial attractiveness of the
proposed project



INTERNAL RATE OF RETURN
METHOD
The internal rate of return (IRR) is the rate at which the
discounted net returns equal to the original investment
on the project.
This also implies that the rate of return is the discount
rate which makes NPV = 0.
The formula for calculating IRR is:


3 1 2
0
2 3
0
1
0
1
(1 ) (1 ) (1 ) (1 )
(1 )
0
(1 )
n
n
n
t
t
t
n
t
t
t
C C C C
C
r r r r
C
C
r
C
C
r
=
=
= + + + +
+ + + +
=
+
=
+

INTERNAL RATE OF RETURN


METHOD
Where,

C
t
= cash flow at the end of year t
n = Life of the project
r = discount rate
C
0
= Initial investment
1 / (1 + r )
t
= known as discounting factor or PVIF
i.e present value interest factor.
CALCULATION OF IRR
Uneven or nonnormal Cash Flows:
Calculating IRR by Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows.
If the calculated present value of the expected cash
inflow is lower than the present value of cash
outflows, a lower rate should be tried.
On the other hand, a higher value should be tried if
the present value of inflows is higher than the present
value of outflows.
This process will be repeated unless the net present
value becomes zero.

ACCEPTANCE RULE FOR IRR
Accept the project when r (IRR) > k (WACC).
Reject the project when r (IRR) < k (WACC).
May accept the project when r = k.
In case of independent projects, IRR and NPV rules will
give the same results if the firm has no shortage of
funds.
In case of projects with equal IRR & different NPV,
select project with higher NPV as it is consistent with
firms wealth maximisation objective.


ADVANTAGES OF IRR METHOD
It considers time value of money.
It is a true measure of profitability as it uses the
present values of all cash flows rather than any
other arbitrary assumption or subjective
consideration.
Whenever a project with higher IRR than WACC
is undertaken, it results in the increase in the
shareholders return. Hence, the value of the firm
also increases.
The percentage figure generally allows a sound,
uniform ranking of project.

PROBLEMS WITH IRR
It is not easy to understand and calculate the IRR as it
involves complex and tedious computational problems.
There may be some investment projects on which no
real value of IRR can be computed, e.g. Social
projects.
The result shown by NPV and IRR may differ if
projects are different in terms of
Expected life of project
Cash outlays
The use of multiple rates might create confusion.


PAY BACK PERIOD
It is the number of years required to recover a projects
cost, or how long does it take to get the businesss
money back?


10 80 60
0 1 2 3
-100
=
CF

Cumulative -100 -90 50
Payback

2 + 30/80 = 2.375 years
0
100
2.4
-30
Strengths of Payback:
1. Provides an indication of a projects risk and
liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the time value of money.
2. Ignores CFs occurring after the payback period.
3. It is a measure of capital recovery & not
profitability.
PAY BACK PERIOD
DISCOUNTED PAYBACK PERIOD
(DPBP)
10 80 60
0 1 2 3
CF
t
Cumulative
-100
-90.91 -41.32 18.79
Discounted
payback
2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discounted
rather than raw CFs.
PVCF
t
-100
-100
9.09 49.59 60.11
=
ACCOUNTING RATE OF RETURN ACCOUNTING RATE OF RETURN
The accounting rate of return is the ratio of the average
profit after-tax divided by the average investment.

ARR = Average Profit After Tax *100
Average Investment
Where;
Average Investment = Initial Investment + Scrap Value
2
A variation of the ARR method is to divide average
earnings after taxes by the original cost of the project
instead of the average cost.

ACCEPTANCE RULE OF ARR
This method will accept all those projects whose ARR is
higher than the minimum rate established by the
management and reject those projects which have ARR
less than the minimum rate.

Accept if ARR > minimum rate.
Reject if ARR < minimum rate

This method would rank a project as number one if it
has highest ARR and lowest rank would be assigned to
the project with lowest ARR.


ACCOUNTING RATE OF RETURN

The ARR method has certain advantages as:

It is very simple to understand.
This method takes into account all the profits
during the life time of the project, whereas pay
back period ignores the profits accruing after
the pay back period .
Dependency on accounting data which is
readily available.
Shows the profitability of the project.

ACCOUNTING RATE OF RETURN
The disadvantages of ARR include:
It is based on accounting profit rather than cash flows.
Time value of money is ignored.
This method does not account for the profits arising on
sale of profit on old machinery on replacement.
ARR method does not consider the size
of investment for each project.
It may be time that the competing ARR of two projects
may be the same but they may require different
average investments. It becomes difficult for the
management to decide which project should be
implemented.




CASE STUDY OF TREE HOUSE
EDUCATION IPO 2011
ASSUMPTIONS:
Cost of capital i.e. discount rate is 15%
Inflation rate for calculating future cash flows is
taken as 55%
Initial investment is assumed to be Rs 50
million
The cash flow of year 2007 is taken as cash
flow of 2012 and cash flow of year 2008 as
2013 and so on....

CALCULATION OF NET
PRESENT VALUE
YEAR NET CASH FLOW INFLATED CASH
FLOWS
DIS
FACTOR@15%
P.V OF C.F
2012 2.8 4.34 0.87
3.7758
2013 -1 -1.55 0.756
-1.1718
2014 19.66 30.47 0.657
20.01879
2015 81.98 127.06 0.571
72.55126
2016 175.27 271.67 0.497
135.01999
(Rs. In millions)
NPV OF CASH FLOW=230.19404(Rs
million)
Therefore NPV of the project
= NPV Of Cashflow - Initial Investment
= 230.19404 50
=180.19404(Rs million)

CALCULATING THE
PROFITABILITY INDEX
Profitability index= NPV/cost of assets * 100
=180.19/50 * 100
=360.38(%)

The NPV is positive and the profitability index
is more than unity. Hence the project may be
accepted.


CALCULATION OF THE
PAYBACK PERIOD
YEAR INFLATED CASH
FLOWS
2012 4.34
2013 -1.55
2014 30.47
2015 127.06
2016 271.67
Payback period
= 4.34 + (-1.55) + 30.47 + 16.47
= 50million.

That is 3 years + (16.47*12)/127.06

= 3years + 48 days

=36 months and 48 days.
CONCLUSION
From the above study, we can conclude that
DCF is a better technique than NON DCF.
As DCF technique considers the time value of
money which is a very important factor.
On the basis of time value you can consider
the future value and discount them and judge
whether to invest or not on the basis of NPV of
a project.


While in NON-DCF, time value factor is not
taken which is a disadvantage.
It does not take into account any discount
factor. On the basis of payback period also you
cannot judge the value of firm.
Cashflows after the payback period are not
taken into consideration which does not let you
know the over all return on investment and the
profitability.