Introduction to Discounted Cash Flow and Project Appraisal. Charles Ward

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1 Introduction to Discounted Cash Flow and Project Appraisal Charles Ward

2 Company investment decisions How firms makes investment decisions about real projects (not necessarily property) How to decide which projects should be accepted/rejected. What discount rate to use What cash flows to include

3 What is a firm? We take as our base, a company with shares listed on the stock market. The company is owned by shareholders The company can borrow money by issuing bonds (paying interest) The directors of the company take decisions to make the shareholders better off

4 What is a project? Typically firms have cash which they want to invest They should invest in projects that make a profit Good projects should make their shareholders most profit Good projects should make their shareholders wealthy Examples: Buying a new machine, building a new factory, taking over another company, eliminating an unsuccessful division.

5 Financial analysis In order to analyse the financial position of a firm or individual We require Value of CASH FLOWS Time at which we receive or pay out the cash An interest rate to bring the cash flows back to the present time

6 How do we measure benefit? Project A Invests 100 NOW and sells 100 and 150 during years 1 and 2 respectively. Other annual costs = 25 Project B Invests 100 NOW and sells 50 and 225 during years 1 and 2 respectively Other annual costs = 25

7 Profit A reported Year 1 Year 2 (Investment 100) Depreciation Other costs Sales Profit 25 75

8 Profit B reported Year 1 Year 2 (Investment 100) Depreciation Other costs Sales Profit

9 Cash flows for A and B T=0 T=1 T=2 Firm A -100 Costs Sales NCF Firm B Costs Sales NCF

10 Differences Cash Flows not profit Assets bought give rise to negative cash flows but are not costs In accounting terms, asset use is reflected in cost= depreciation Depreciation is not a cash flow Accounts are for periods, financial analysis uses points in time

11 Review 1 A company builds luxury houses. It takes on a contract to build a house in London for 400 million. The contract will take 2 years to complete. The costs are 200 million in year 1, 200 million in year 2. The buyer pays a deposit of 50 million at the start of the contract and 100 million at the beginning of year 2 and the balance at the end of year 2. Draw up the balance sheet of the company at the end of year 1.

12 Review 2 One theory of company behaviour is called Agency theory which suggests that the directors of the company will seize opportunities to benefit themselves at the expense of shareholders by perks and personal benefits such as large company cars/planes/country house retreats What will be the result of such action? How would you stop it? (Threatening murder is not an acceptable answer).

13 We use Expected Cash Flows Accountants adjust profits (a) (b) (c) to be conservative: Not wanting to count chickens before they are hatched. on realisation of events not the receipt of cash: Sales occur when delivered or invoiced, not when paid. Provide for known problems: bad debts

14 Given the expected cash flows We can discount them at an appropriate rate to arrive at an Net Present Value (NPV)

15 The Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF s + Initial Investment Acceptance Criteria: Accept if NPV > 0 (on the assumption that finance will always be available for good projects) Ranking Criteria: Choose the highest NPV

16 Consequences of NPV Suppose firm (10 million shares with market price of 2) takes on project with NPV of 2 million. NPV rule implies that share price will rise from 2 to 2.20 on the decision being publicised

17 The Internal Rate of Return (IRR) Rule IRR: the discount rate that sets NPV to zero Minimum Acceptance Criteria: Accept if the IRR exceeds the required return. Ranking Criteria: Select alternative with the highest IRR possibly Disadvantages: IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments Biased towards short term projects Advantages: Easy to understand and communicate

18 WORKED EXAMPLES: PROJECTS S & B Consider two simplified projects: Year Project S ( m) Project B (3m) Both last exactly three years, have an initial investment in year zero (today) and generate income at the end of years 1 to 3 The cashflows in each year are net cashflows, that is income less any costs In property a net cash flow is sometimes called the net operating income

19 NPV at various discount rates rate NPV (S) NPV(B) 0.0% % % % % % % % % % %

20 % 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% IRR (S) = 17.92%, IRR (B) = 16.06%

21 NPV & IRR: TOWARDS AN EXPLANATION Consider Project S. We must pay out 150 now Suppose we can borrow this at 10% We ll use our income to repay the debt End of Year One: Debt = 150(1.1) = 165 Repay 50 from income: Debt = = 115 End of Year Two: Debt = 115(1.1) = Repay 75 from income: Debt = = 51.5 End of Year Three: Debt = 51.5(1.1) = Income = 88. Repay debt leaving surplus of The present value of this surplus is X = x (1.1) -3 So X = This is the NPV at 10%

22 Project S continued Suppose we borrowed 150 at 17.92% At end of year 1, we owe and pay off with the CF of 50 At end of year 2, we owe and pay off with CF of 75 At end of year 3, we owe 88 and pay off with CF of 88 = no Surplus IRR = the maximum amount we could pay on financing the project

23 DECISION MAKING RULES NPV Discount the project cashflows at the firm s target rate. If the NPV is positive, accept the project. (ii) If choosing between projects, pick the project with the higher NPV IRR Calculate project s IRR. If this exceeds the firm s target rate, the project is acceptable. If choosing between projects, the IRR may give misleading results.

24 DECISION MAKING Target Rate usual suspects: cost of capital, opportunity cost (returns on other assets), risk free rate (= time preference & anticipated inflation) & risk premium reflecting uncertainty of cashflow Evaluating single conventional investment projects NPV and IRR rules are identical. If project has a POSITIVE NPV at the Target Rate then the IRR MUST be greater than the NPV. A project with a positive NPV adds wealth that is, the value of future cashflows, properly discounted, is greater than the outlay today. When comparing two mutually exclusive projects, NPV and IRR MAY GIVE DIFFERENT ANSWERS. To preview the NPV is the correct answer

25 MUTUALLY EXCLUSIVE PROJECTS Year Project X ( m) Project Y ( m) X Y Decision Select Y Select Y Do neither IRR 17% 16%??? X

26 MUTUALLY EXCLUSIVE PROJECTS - 2 Project X has the higher IRR Project Y generates the higher 10% and 15% The issue is scale of investment Project X has outlay of 1,000 Project Y has outlay of 3,000 How to deal with the IRR issue Generate a third project that is doing Y rather than doing X

27 Using the IRR with mutually exclusive projects If Y not X has an acceptable IRR then accept Y Time X Y Y not X IRR 17.0% 16.4% 16.1%

28 NON-CONFORMING CASHFLOWS A conforming cashflow has one sign change Non-conforming c/flow has >1 sign change This example has two sign changes. It has two IRRs IRR1 = 11.21% IRR2 = 25% Between those two rates, the NPV is positive Time CF

29 Other issues The scale of investment and the impact on the firm. Are there budgetary constraints? What happens if another project comes along? The timings of cash flows in particular in relation to the firm s liabilities. If the cash flows are 3-4 years ahead, can we wait that long? Relative risk are the projects of the same type? Should we be using the same target rate of return? A firm may have different hurdle rates for different classes of projects? Confidence in the cash flow forecasts this is really risk again, but how sure are you of the costs and incomes used in the analysis?

30 Incremental Cash Flows Sunk costs are not relevant Opportunity costs do matter. Side effects matter. Erosion and cannibalism are both bad things. More difficult issues include Overhead costs and other indirect costs.

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