presentation - session 14

7/27/2019 Presentation - Session 14

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Investment AppraisalPart II



© Copyright Coleago 2010

Learning Objectives

DCF Learning how to carry out a Discounted Cash Flow Analysis

NPV Appreciate the relevance of Net Present Value to

decision making including a worked example

IRR Understand the concept of the Internal Rate of

Return

AdditionalMaterial

Expected Net Present Value: a tool to incorporateprobable outcomes

1




Learning Objectives

DCF Learning how to carry out a Discounted Cash Flow Analysis




Return

AdditionalMaterial


2



A simple way to examine a project

Invest $560 now to get a $200 per year for the next three years

Decision Rule: Invest in all projectswith a positive Net Value

Result: Invest

Year Cash Flow $

2011 (560)

2012 200

2013 200

2014 200

Net Value 40

© Copyright Coleago 2010 3



Another investment opportunity

Invest $500 now

Receive immediately

– 10,000 Japanese Yen

– 200 Euros

– 350 Swiss Francs

Invest?

– Value = 10,000 + 200 + 350 – 500 = 10,050

To assess the opportunity the different currencies must be converted to acommon currency, for example $, to allow a “like-for-like” comparison




If you had a choice of a today or a dollar in a years time – which would you

choose?

– A dollar today!

A dollar in a years time is worth less than a dollar today as a dollar today can beinvested in a bank, risk free, and will be worth more than the dollar received in ayears time

To compare a cash flow now with a cash flow in the future you have to take intoaccount the time value of money

A dollar today is worth more than a dollar tomorrow

Now Year Later

$1 $1*(1+5%) = $1.05




Making a like-for-like comparison

We cannot compare directly $560 investedin 2011 with, for example, $200 receivedin 2012

– $200 received in a year’s time is worthless than $200 now

We need to convert the future cash flowsto an equivalent amount receivable now –the task of Discounted Cash Flow

Year Cash Flow $

2011 (560)

2012 200

2013 200

2014 200

Net Value 40




Compound interest

Compound interest answers the question

– What will a $ invested now be worth at some point in the future

Year Value of $ Calculation Alternatively

0 $ 1.00 $ 1.00 $ 1.00

1 $ 1.05 $ 1.00 * ( 1 + 5%) $ 1.00 * ( 1 + 5%)

2 $ 1.1025 $ 1.05 * ( 1 + 5%) $ 1.00 * ( 1 + 5%)

2

3 $ 1.157625 $ 1.1025 * ( 1 + 5%) $ 1.00 * ( 1 + 5%)3




Discounting

Discounting answers the question

– What would a $ receivable in the future be equivalent to if it were receivednow?

Year $s received in

the future

CalculationEquivalent

Receivable Now $

0 $ 1.00 $ 1.00 $ 1.00

1 $ 1.05 $ 1.05 / ( 1 + 5%) $ 1.00

2 $ 1.1025 $ 1.1025 / ( 1 + 5%)2 $ 1.00

3 $ 1.157625 $ 1.157625 / ( 1 + 5%)3 $ 1.00




Discounting – further examples

Year AmountReceived $

Equivalent AmountReceived Now $

Calculation

0 $ 1.00 $ 1.00 $ 1.00

1 $ 125 $ 119.05 $ 125 / ( 1 + 5%)

2 $ 210 $ 190.48 $ 210 / ( 1 + 5%)2

3 $ 200 $ 172.77 $ 200 / ( 1 + 5%)3




Simple investment problemsyou can earn 5% at the Bank of England or

Year Bank 1 Bank 2 Bank 3

0 £(1.00) £ (1.00) £ (1.00)

1 £ 1.10 £ 1.05 £ 1.02

Invest?

Year Bank 1 Bank 2 Bank 3

0 £(1.00) £ (1.00) £ (1.00)

1 £ 1.10 £ 1.05 £ 1.02

Year 1 equivalent atYear 0 at 5%

£1.10 / (1+5%) =£1.047

£1.05 / (1+5%)= £1.00

£1.02 / (1+5%) =£0.97

Invest?





Learning Objectives

DCF

Learning how to carry out a Discounted Cash Flow Analysis




Return

AdditionalMaterial


14



Comparing like-for-like

Decision Rule: Invest in all projects with a positive NPV

Result: Do not invest because the NPV is negative

Year Cash Flow $ Calculation at 5% Equivalent $ Now

2011 (560) (560) (560.00)

2012 200 = 200 / ( 1 + 5% ) 190.48

2013 200 = 200 / ( 1 + 5% )2 181.41

2014 200 = 200 / ( 1 + 5% )3 172.76

Net Value 40 Net Present Value (15.35)




Worked Example


Result:


2011 (600)

2012 220

2013 230

2014 240

Net Value 90 Net Present Value




Worked Example - Solution


Result: Invest


2011 (600) (600) (600.00)

2012 220 = 220 / ( 1 + 5% ) 209.52

2013 230 = 230 / ( 1 + 5% )2 208.62

2014 240 = 240 / ( 1 + 5% )3 207.32

Net Value 90 Net Present Value 25.46




Introducing Risk

So far we have compared the returns from one bank with another bank

– If both banks were generating a return of 5% you would be indifferentbetween the two

If you had the choice between investing in a bank at 5% and investing in a 3G

Mobile Business at 5% which would you prefer?

– The bank, as its safer

What might persuade you to invest in the 3G Mobile Business?




Risk

An investment decision requires the investor to take on risk

The risk is that there may be variability in the level of the future cash flowsactually received

The Future

$

Now ?? ? ? ?

?




A safe dollar is worth more than a risky dollar

You are faced with two investment decisions

– Invest in the Bank with an anticipated return of 5%

– Invest in 3G Mobile with an anticipated return of 5%

A rational investor would prefer the Bank where the expected variability is very

low

– A rational investor can earn 5% return risk free and so would not be attractedto a riskier investment with the same level of anticipated return

In order to persuade an investor to invest in 3G and assume additional risk theywill demand an additional return in excess of the return achievable risk free at

the Bank

– This is called the risk premium




Selecting a suitable discount rate

In using a discount rate of 5% we have implicitly assumed that the riskassociated with this investment is the same as investing in a bank

– The investor only needs to be compensated for the Time Value of Money


2011 (600) (600) (600.00)

2012 220 = 220 / ( 1 + 5% ) 209.52

2013 230 = 230 / ( 1 + 5% )2 208.62

2014 240 = 240 / ( 1 + 5% )3 207.32

Net Value 90 Net Present Value 25.46


Suppose the previous example represented an investment in a 3G



Suppose the previous example represented an investment in a 3GMobile business

The investor now needs to be compensated for the Time Value of Money or the

Risk Free Rate and a Risk Premium (say 5%)

Discount Rate = Risk Free Rate + Risk Premium

Discount Rate = 5% + 5% = 10%


2011 (600) (600) (600.00)

2012 220 = 220 / ( 1 + 10% ) 200.00

2013 230 = 230 / ( 1 + 10% )2 190.08

2014 240 = 240 / ( 1 + 10% )3 180.31

Net Value 90 Net Present Value (29.61)




W k d E l Di R f 10%



Worked Example – at a Discount Rate of 10%

It is normal to assume that all cash flows in a period take place either at the midpoint of the period or at the end of the year

Here we have assumed that they occur at the end of the year and we discount back to1st January 2011

2011 2012 2013 2014 2015 2016 2017

Revenue 12,000 24,000 30,000 40,000 55,000 75,000

Gross Profit 8,400 17,280 22,200 30,400 42,900 60,000Operating Costs (14,000) (14,280) (14,566) (14,857) (15,154) (15,457) (15,766)

EBITDA (14,000) (5,880) 2,714 7,343 15,246 27,443 44,234

Capital Expenditure (5,000) (2,000) (500) (250) (250) (250) (250)

Free Cash Flow (19,000) (7,880) 2,214 7,093 14,996 27,193 43,984

Discount Factor 1.10 1.21 1.33 1.46 1.61 1.77 1.95

Discounted FCF (17,273) (6,512) 1,664 4,845 9,311 15,350 22,571

Net Present Value $29,995© Copyright Coleago 2010 26

E i C l l t NPV f th N D t P j t



Exercise – Calculate a NPV for the New Data Project

Assume cash flows take place at the end of the year

Calculate the NPV as at the 1st January, 2011

Use a Discount Rate of 10%

– Step 1 – Calculate the Discount Factors

– Step 2 – Divide FCF by the Discount Factor

– The result should be smaller!

– Step 3 – Add up the discounted cash flows


W k d E l t Di t R t f 10%



Worked Example – at a Discount Rate of 10%

2011 2012 2013 2014 Total

Free Cash Flow n/a

Discount Factor 1.1

Discounted FCF


The rough guide to financial hurdles NPV



The rough guide to financial hurdles - NPV

Net Present Value

– Financial theory states that provided cash flows are discounted at theappropriate discount rate any positive NPV will enhance shareholder value

– In reality business cases should be significantly positive at the appropriatediscount rate but the absolute value of the NPV will depend on the scale of

the project




Discounted Cash Flow & NPV Strengths



Discounted Cash Flow & NPV - Strengths

Deals with the timing of cash flows

Deals with the risk of cash flows

Uses all appropriate cash flows

Deals with scale

Focuses on increasing shareholder value

Can be used at any stage of maturity of a project or company


Discounted Cash Flow & NPV - Weaknesses



Discounted Cash Flow & NPV - Weaknesses

Not easily understood by managers

Difficult to perform

Requires an appropriate Discount Rate

Requires comprehensive financial forecasts


Learning Objectives




Learning Objectives

DCF Learning how to carry out a Discounted Cash Flow

Analysis



IRR Understand the concept of the Internal Rate of Return

AdditionalMaterial


33

The Internal Rate of Return: IRR



The Internal Rate of Return: IRR

Let’s look at the two previous examples we used, applying a discount rate of 5%and then 10% to a series of future cash flows.

There must be a discount rate which produces an NPV of zero.

This is the internal rate of return.

Year Cash Flow

$

Discount Rate

of 5%

Discount Rate of

10%2011 (600.00) (600.00) (600.00)

2012 220.00 209.52 200.00

2013 230.00 208.62 190.08

2014 240.00 207.32 180.32

NPV 25.46 (29.60)

Discount Rate of

7.22%

(600.00)

205.19

200.08

194.73

Nil


Internal Rate of Return




The Discount Rate used in NPV calculations is set by management based on a

review of the returns achievable on similar projects

The Internal Rate of Return (IRR) is closely related to Discounted Cash Flowtheory

The IRR is the “Discount Rate” which, when applied to a cash flow series,

generates a Net Present Value of zero

The IRR is the return generated by the investment


Calculating the IRR using Excel



g g

Calculating the IRR is an iterative process, laborious and time consuming

Do not attempt to calculate an IRR, use Excel!

Excel contains an Internal Rate of Return function

– = IRR ( values, guess )

The Values are the series of cash flows to be evaluated

The guess is an initial estimate of the IRR to assist Excel in the iterativecalculation that it performs

– This does not always need to be included


Internal Rate of Return - Strengths



g

Takes into account all cash flows

Timing is explicitly dealt with

Calculating a discount rate is not required

Gives a percentage result which is usually better understood


Internal Rate of Return - Weaknesses



IRR calculations say nothing about the size of a project

If the cash flows contains a sequence of negative, then positive then negativevalues etc., then there can be more than one value of the IRR


The rough guide to financial hurdles - IRR




IRRs will vary significantly depending on the nature of the project

The minimum acceptable range is probably 15% to 20%

20% to 50% is probably a reasonable expectation for major investment

projects

Excessively high IRRs 60-70% plus may also attract extra scrutiny




Session Summary



Investment AppraisalPart IIAdditional Material



Expected Net Present Value



In order to calculate an Expected NPV a number of different scenarios need to

be identified and cash flow projections made for the same project

The free cash flow projections for each scenario are discounted to give a NPVfor each scenario

– If four scenarios were identified there would be 4 separate NPVs

Each scenario is given a probability of occurring

– The sum of all the probabilities must sum to 1 or 100%

Each NPV is multiplied by the probability of the scenario occurring

The sum of each of these calculations is then computed to give the ExpectedNet Present Value


Expected Net Present Value for Multi Media Messaging (MMS)



Scenario NPV$000s

Probability Expected NPV$000s

Scenario 1 – MMS’s OK 30 30% 9

Scenario 2 – MMS Goes MM 40 10% 4

Scenario 3 – Teens love MMS 25 30% 7.5

Scenario 4 – MMS disappoints 15 30% 4.5

Total 100% 25


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