Chapter 3 – Investment appraisal using
discounted cashflows
Chapter agenda
Discounting
single values
Discounting
Discounting
annuities
Time value of
money
Discounting
Compounding
perpetuities
Chapter 3
NPV Pros & Cons
Invesment
appraisal
IRR Pros & Cons
What is the time value of money (TVM)?
Money has a time value. Money received today is worth more than the same sum received
in the future.
This is due to inflation, the ability to earn interest on monies received today than later,
uncertainty in the market
TVM gives rise to two concepts
1. Compounding
2. Discounting
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Rukmal Devinda
Compounding
In its simplest, this means a sum invested today earn interest into the future.
Compounding involves calculating the sum of money received at the end of the investment.
Thus it is essentially a future value calculation
Future value can be calculated using the following equation
𝐹 = 𝑃(1 + 𝑟)!
where
F = Future value
P = Present value
R = Interest rate per period
n = number of periods
Example – Compounding
An investor has $15,000 to invest now for 5 years at an interest rate of 10% per year.
What will be the value of the investment after five years?
Discounting
This is the opposite of compounding. This involves calculating the present value of a sum
received in the future.
In physical project undertaking, cashflows may arise at different points in time. Discounting
is crucial to bring these cash flows arisen at different points in time to the present.
Future value can be calculated using the following equation
𝐹
𝑃=
(1 + 𝑟)!
This can also be written as
1
𝑃=𝐹𝑥
(1 + 𝑟)!
1
𝑇ℎ𝑖𝑠 𝑖𝑠 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑡ℎ𝑒 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟 (𝐷𝐹).
(1 + 𝑟)!
DF can be easily found using DF tables.
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Example – Discounting
An investor is expected to receive $100,000 in 10 years.
What is the present value of this sum if the interest rate per annum is 6%?
Example – Discounting - 2
An investor is expected to receive the following cashflows into the next 3 years
Year Cashflow ($)
1 10,000
2 20,000
3 15,000
What is the total present value of these cash flows assuming the interest rate per annum is
10%?
It must be noted that in the context of project appraisal, the interest rate is referred to as
the cost of capital, required rate of return or discount rate.
Discounting annuities
An annuity is when the same cash flow occurs for a number of years.
Example – Annuities
You are to make $2000 payments in each of the next 3 years. If the interest rate per annum
is 5% calculate the present value of the annuity.
Year Cashflow DF @ 5% PV
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The PV can be easily found using the annuity factor (AF). This is simply the addition of
discounting factors.
𝑷𝑽 = 𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝑿 𝑨𝑭
The AF can be calculated using the following formula
𝟏 − (𝟏 + 𝒓)"𝒏
𝑨𝑭 =
𝒓
Alternatively, the AF can be found using the cumulative discount factor tables
Discounting perpetuities
Perpetuity is when the same cash flow is received indefinitely (to infinity).
The present value of a perpetuity is calculated as follows.
𝐶𝐹
𝑃𝑉 =
𝑟
Example – Perpetuity
You are to receive $50 from an investment to infinity. If the discount rate is 10% what is the
PV of the perpetuity?
Growing perpetuity
The present value of a growing perpetuity is calculated as follows.
𝐶𝐹
𝑃𝑉 =
𝑟−𝑔
Example – Perpetuity with growth
You are to receive $50 in 1 year’s time and the cash flow grows by 5% to infinity. If the
discount rate is 10% what is the PV of the growing perpetuity?
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Net present value (NPV)
This is considered to be the MOST SUPERIOR investment appraisal technique.
NPV is calculated as
𝑵𝑷𝑽 = (𝑪𝒐𝒔𝒕 𝒐𝒇 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕) + 𝑺𝒖𝒎 𝒐𝒇 𝑷𝑽 𝒐𝒇 𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒆𝒅 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔
How to make the investment decision using NPV?
If NPV is positive – Project is financially viable.
If NPV is negative – Project is not financially viable.
If NPV is zero – The project is breaking even
If a company has two or more MUTUALLY EXCLUSIVE PROJECT, then only the project with
the HIGHEST NPV must be accepted
When calculating NPV the following must be considered
1. Only the cash items must be considered and all non-cash items must be ignored
2. Only relevant future cash flows must be considered
3. Sunk costs and committed costs must be ignored
The cost of obtaining a geological report on the area before a mining investment starts is an
example of sunk cost. Whether the mining op. is undertaken or not, the mining company
has to bear this cost. Thus it is sunk (already gone)
You are to undertake a small project on the factory floor that you are currently working
which has been acquired for rent. The rent here is an example of a committed cost.
Whether the project is undertaken or not, you need to bear the rent. Thus it is committed
(cannot prevent)
Example - NPV
An organisation is considering investing in a project that costs $1000,000 today. The
following are the cashflows expected from the project into the next 4 years.
Year Cashflow ($)
1 100,000
2 300,000
3 550,000
4 300,000
What is the NPV of the project assuming the company has a cost of capital of 10%?
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Pros & Cons of NPV
Pros Cons
Takes into account TVM Relatively complex compared to ARR and
Payback
NPV is based on cashflows Not easily understood by non-finance
managers
NPV shows absolute returns Does not show a % return
Positive NPV means shareholders’ wealth is
maximised
Internal rate of return (IRR)
This is another investment appraisal technique that makes use of TVM.
IRR is simply the discount rate at which the NPV of a project becomes zero. Thus it is the
breakeven return.
IRR is calculated using the following equation
"#$!
𝐼𝑅𝑅 = 𝐷𝐶𝐹! + 𝑥 (𝐷𝐶𝐹( − 𝐷𝐶𝐹! )
("#$! &"#$" )
DCFL - Lower DCF
DCFH - Higher DCF
NPVL - Lower NPV
NPVH - Higher NPV
How to make an investment decision using IRR?
If IRR of the project > Cost of capital (Or hurdle rate) ---- Accept the project
If IRR of the project < Cost of capital (Or hurdle rate) ---- Reject the project
Steps in calculating IRR
1st step - Calculate NPVs at two different discount rates (Higher and Lower)
2nd step - Substitute the discount rates and NPVs to the IRR equation
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Example - IRR
An organisation is considering investing in a project that costs $1000,000 today. The
following are the cashflows expected from the project into the next 4 years.
Year Cashflow ($)
1 100,000
2 300,000
3 550,000
4 300,000
a) What is the NPV at 6% and 12% discount rates?
b) What is the IRR? Should the company undertake the project if the hurdle rate is 11%
c) Show the answer diagrammatically
Pros and cons of IRR
Pros Cons
IRR considers TVM IRR involves a complex calculation
IRR shows % returns thus easy to understand Does not show an absolute return
IRR is based on cashflows When there are unconventional cashflows
there can be multiple IRR or no IRR at all
Shareholder wealth in maximised if
IRR > Cost of capital
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