7-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Discount cash Flow Valuation Chapter Seven

2 Discounted Cash Flow (DCF) DCF is used to evaluate an investment to see if it meets profit objectives Uses the concept of Time Value of Money Two methods –Net present value –Internal rate of return

7-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Net Present Value (NPV) Net present value (NPV) is the difference between an investment’s market value (in today’s dollars) and its cost (also in today’s dollars). An investment is worth undertaking if it creates value for its owners. Value is created by identifying an investment that is worth more in the marketplace than it costs to acquire. NPV provides a measure of how much value is created by undertaking an investment.

7-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan NPV Steps in calculating NPV: The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.

7-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan NPV Illustrated Initial outlay ($1100) Revenues$1000 Expenses 500 Cash flow $500 Revenues$2000 Expenses1000 Cash flow$1000 – $ $ $500x $1000x NPV

7-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan NPV An investment should be accepted if the NPV is positive and rejected if it is negative. NPV is a direct measure of how well the investment meets the goal of financial management—to increase owners’ wealth. A positive NPV means that the investment is expected to add value to the firm.

7 Example: New product development costs and returns are shown in the table below If cost of capital is 16%, is this project viable?

8 Example: Continue Before we proceed we must find the net cash flows for each year

9 The net cash flows can be entered into the calculator CFi 2ndF CA{MODE} (clears cash flows.) +/- 420 Data +/- 105 Data 71 Data 420 Data 240 Data 160 Data Press On/C 2ndF CASH{CFi} 16 ENT (interest rate) ▼ COMP The NPV = The net present value of the sequence of cash flows is $20,050 when cost of capital is 16% Project is viable Example: Continue

10 Is the project viable if the cost of capital is 18%? To see what happens when the cost of capital is increased to 18%, Press ▲ Scrolls up to the interest rate screen. 18 ENT Enters the new interest rate. ▼ COMP Computes the new NPV NPV = The NPV is now (-$8,640). So at 18% NPV = (-$8,640) which means the project is going to lose money at this cost of capital. This project is no longer viable as the costs are greater than the returns. Example: Continue

11 Internal Rate of Return The discount rate that equates the PV of cash inflows with the PV of the cash outflows The highest rate of capital at which a company could afford to undertake the project

7-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future cash flows with the initial cost. A project is accepted if: IRR > the required rate of return The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.

7-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example 1—IRR Initial investment = –$200 Year Cash flow 1$ Find the IRR such that NPV = = – (1+IRR) = + + (1+IRR) 1 2 3

7-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example 1—IRR (continued) Trial and Error Discount ratesNPV 0%$100 5%68 10%41 15%18 20%–2 IRR is just under 20%—about 19.44%

15 What is the break even point for this project? That is, find the IRR (assuming all the cash flows are still in the calculator) Press ▲ Scrolls up to the interest rate screen. COMP Computes the IRR IRR = 17.38% As long as the cost of capital is below 17.38% this project is viable Example: Continue

16 Illustration: Proposal to purchase new machinery will cost $100,000 with a terminal salvage value of $10,000 after 6 years –Selling price = $12/unit –Variable cost = $4/unit –Selling cost = $1/unit –Manufacturing overheads - depreciation = $15,000 p.a. –Maintenance = $2000 p.a.

17 –Overheads = $3000 p.a. –Administrative and selling overheads = $10,000 p.a. –Sales = 10,000 p.a. –Tax rate = 0.4 –Weighted cost of capital = 20% after tax What is the NPV for this project? The first step is to find the yearly net cash flows Illustration:

18 Cash flow year 1 = (12-(4+1))x10,000-2,000 = 68,000 Depreciation based on straight line depreciation of $100,000 less $10,000 salvage Tax based on cash flow, less depreciation, excl. capital items Salvage value added to final year cash flow Illustration:

19 Illustration:

20 +/ Data 46,800 Data 56,800 Data 2ndF CASH{CFi} 20 ENT (interest rate) ▼ COMP NPV = $58,982 OR +/ Data 46,800 (x,y) 5 Data 56,800 Data 2ndF CASH{CFi} 20 ENT (interest rate) ▼ COMP NPV = $58,982 The project is viable! Press ▲ COMP IRR = 41.48% Illustration:

7-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Advantages of IRR Popular in practice. Does not require a discount rate. The IRR appears to provide a simple way of communicating information about a proposal.

7-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Problems with IRR Multiple rates of return –Occurs if more than one discount rate makes the NPV of an investment zero. –This will happen when there is more than one negative cash flow (non-conventional cash flows). Mutually exclusive investment decisions –Project is not independent  mutually exclusive investments. Highest IRR does not indicate the best project.

7-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Multiple Rates of Return Assume you are considering a project for which the cash flows are as follows: Year Cash flows 0 –$ –100

7-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Multiple Rates of Return To find the IRR on this project NPV is calculated at various rates: at 10%:NPV =-$1.74 at 20%:NPV = at 30%:NPV = 0.06 at 40%:NPV = Two questions :  1. What is going on here?  2.How many IRRs can there be? NPV crosses zero

7-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan NPV Profile