Study On Discounted Cash Flow Techniques Finance Essay - Free Essay Example

In current practice, managers use DCF (discounted cash flow) and Traditional method analysis to estimate the investment in financial terms. In DCF method considers the time value of money in which reduces the time value of money progressively and it consist with NPV (Net Present Value) approach and IRR (Internal Rate of Return method). This could lead to more popularize investment appraisal techniques among the managers. A valuation method used to evaluate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Net Present Value The NPV which based on a required rate of return to each years projected cash flow, both in and out, is the application of discount factors. If the NPV is negative, the project should be rejected and if positive, the required rate of return is likely to be earned and the project should be accepted. NPV is especially appropriate for long-term projects, ranking investments by NPV does not compare absolute levels of investment. For Strengths of NPV by considering the time value of money, it also takes factors, like interest rates, cost of capital and investment opportunity costs into account. NPV not looks at profits and losses the way accounting systems do, it looks at cash flows. It can be tricky to determine and highly sensitive to the discount percentage. The technique works by discounting a projects cash flows by the Cost of Capital set by the organization. Each cash inflow and/or outflow is discounted back to its PV. Then they are summed. Each cash inflow and/or outfl ow is discounted back to its present value (PV). NPV = PV-costs (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of periods N, and the net present value NPV, the internal rate of return is given by r The NPV rule states that a project should be undertaken should its NPV be positive (Ross et al, 2005). The NPV rule includes the cost of capital or the discount rate to helping to take risk into account and covering any uncertain cash flows that may arise. It only includes the relevant costs, and it only takes these costs when they occur. The NPV rule uses cash flows instead of earnings, it uses all the cash flows of a project, and it discounts the cash flows with regards to the time value of money. Other forms of investment appraisal tend to ignore at least one, if not more, of these points. The NPV rule also provides a clear rule over the acceptance or rejection of a project. However, only future costs are taken into the analysis. This means t hat past costs are ignored because they do not vary with future decisions. There is also a heavy reliance on the discount rate, often difficult to calculate, and as a result, the cash flows can be complicated to predict. Cash flows are usually assumed to take place at the end of each year, but in practice, this is an over-simplification of the issue (Irons, 2004). Internal Rate or Return (IRR) The definition of IRR is based on NPV. In general terms, IRR is the value for r when the NPV equal to zero. This can be formulated as below   Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€š It is the method favored by many accountants and finance people, possibly the ones at your company. It provides a simple hurdle rate for investment decision-making. It is not as easy to understand as some measures and not as easy to compute. Computational anomalies can produce misleading results, particularly with regard to reinvestments. Having calculated the IRR the company can then accept any projects with an interest rate lower than the IRR and reject any projects with an interest rate higher than the IRR. NPV is highly sensitive to the discount rate, while IRR bypasses the problem of deciding the correct one. IRR is very good for screening projects. IRR is not an absolute amount, its a rate or ratio that more useful for comparing unlike investments, say stocks and bonds. It also more useful for making international comparisons, and comparisons between different periods and different sized firms. The intention here is not to argue for either point of view, but instead to put the issue into balance. Conclusion The aim of Investment appraisal is to help companies make decisions on which project they should invest in. Investment decisions involves making an outlay of something of economic value, usually cash, which the outlay precedes to benefits, so it is vitally important to a business. If a wrong decision is made, the effects on the business could be significant and it might also mean closing down the activity and sell the premises at a significant loss. According to above discussions, discount cash flow techniques have their own advantages and disadvantages. They normally based on some assumptions and reliable forecasting of key values. So its really important and necessary to choose the right and suitable method. Q2. Appraisal Methods for AP Ltd a) AP Ltd. is trying to evaluate 4 new projects. Assume all the 4 projects have a useful life of 10 years. For every business to know where they should invest their money it is essential to research what they should do. There are few main methods of appraisal that should be looked at: 1)  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚   Annual Net Cash flow 2)  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚   Initial Investment 3)  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚   Cost of Capital 4)  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚   Internal Rate of Return (IRR) 5) Net Present Value (NPV) Calculations I am going to use following form to calculate all those answers. ACF(Annual Cash flow)ÃÆ'Æ’-Present value Interest Factor of Annuity (PVIFA)-I.I(Initial Investment)=NPV PVIFA = 1-(1+r)ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¾ÃƒÆ' ¢Ãƒâ€šÃ‚ Ãƒâ€šÃ‚ ¿ or table of PVIFA r Where r = interest rate n = number of periods A) IRR is the value for r when the NPV equal to zero. PVIFA = 0+I.I = 449.400 = 4.494 ACF 100.000 In the PVIFA table, 4.494 in the 10years row equal 18%, which is the IRR for the investment project. So the answer of A is 18% B) The Annual Cash flow in project 1 is  £100,000, Initial Investment is  £449.400 and the Cost of Capital is 14% which equal to 5.216 in the PVIFA table , to calculate the NPV of project we can use the formula as below. NPV = ACFÃÆ'Æ’-PVIFA-I.I =100,000ÃÆ'Æ’-5.216-449.400 =72,200 So the answer of B is  £72.200 C) In project 2, the IRR is 20% of 10 years life time. Then we can found the PVIFA of project 2 is 4.192 from the PVIFA table. And according to the definition of the IRR, we can use the kind of expression as below Cost of Capital = ACFÃÆ'Æ’-IRR20%,10years =70,000ÃÆ'Æ’-4.192 =293,400 So the answer of C is  £293,400 D) We already known the PVIFA14%, 10years is 5.216 and Initial Investment is  £293,400. So the NPV can be formulated as NPV = ACFÃÆ'Æ’-PVIFA-II =70,000ÃÆ'Æ’-5.216-293,400 =71,720 So the answer of D is  £71,720 E) The IRR of project 3 is 14%, and we know PVIFA14%, 10year is 5.216 . In this situation, we can follow the equation as below Net cash flow = Initial investment = 200,000 ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‚ °Ãƒâ€¹Ã¢â‚¬    £38,344 PVIFA14%, 10yr 5.216 So the answer of E is  £38,344 F) Now we know ACF of project is  £38,344, so we can calculate F as follows F= NPV+II = 35,624+200,000 = 6.145 ACF 38,344 Then looking for the PVIFA 6.145 in the 10 years row of PVIFA table, we can find tha t this value equal to 10% which is the Cost of Capital for project 3. So the answer of F is 10% G)According to the table PVIFA12%, 10year is 5.650, and Initial Investment is  £300,000 in project 4. Net cash flow = NPV +I.I = 39,000+300,000 = 60.000 PVIFA14%, 10yers 5.650 So the answer of G is  £60.000 H ) PIVFA= 0+I.I = 300,000 = 5 ACF 60,000 According the PVIFA table, the PVIFA 10years of 5.0 in is 15%, which means internal rate of return for the investment project 4. So the answer of H is 15% b) Both NPV and IRR methods valuable and favorable guides in business practice. Both the IRR and the NPV take account of time value of money, but situations arise where the IRR method leads to different decisions being made from those that would implement the NPV method. However, In some cases, a project with a higher NPV can produce a lower IRR. As in this part, the IRR and NPV method are not always agreed. First, compare the three project 2,3 and 4, we can easy to find that the project 2, which has greater IRR, also get greater NPV. The method of IRR and NPV are agreed. Obviously, for the AP Ltd, the project 2 is better than the project 3 and 4. Second, compare the project 1 with the project 2, the IRR and NPV method are offering conflicting recommendations. The project 2 has greater IRR than the project 1 whereas the project 1 has larger NPV than the project. why the NPV and IRR methods are getting conflicting recommendations and which one we should choose? Conflicting recommendations can be occurred, because projects have differences in size and/or cash flow timing. When one project is larger than another one, the bigger project can has a larger NPV but a smaller IRR, while the smaller project may get a larger IRR but smaller NPV (Emery et al, 2007). As in this case, the project 1 has larger NPV, but smaller IRR than the project 2. In generally, the project which get larger NPV is better. Therefore the method of NPV is superior to the method of IRR, when mutually exclusive projects differ in size. The problem of the difference in cash flow timing is caused by the reinvestment rate assumption (Emery et al, 2007). The method of IRR assumes that the future cash flow of the project can reinvest at the IRR, while use the method of NPV to imply that they are going to earn the cost of capital. And the best assumptions is the one which made my the method of NPV. Because if the project generate the business organization use the cash flow, the organi zation doesnt need borrow money from the other place. In other way, the cost of capital is the opportunity cost of the funds. Again, the method of NPV is superior and has better assumption. Conclusion When using NPV to guide an investment decision, a firm needs to estimate the future cash flow and the return required by its investors. According to finance theory the return required depends on the projects risk and required by the investors is often referred to as the firms cost of capital. Projects offer rates of return less than the cost of capital are not worthwhile undertaking financially, and the return Investment projects offer rates of return higher than the cost of capital add value to the firm. According to those above considerations and the results of the investment appraisal techniques, I would recommend the project 1 for AP Ltd. Because it has a larger NPV and from the financial view that it has the highest return on investment.