7-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a fundamentals of corporate finance 4e, by...
TRANSCRIPT
7-1Copyright 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
7-3Copyright 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.
7-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
NPVSteps 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.
7-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
NPV Illustrated
0 1 2
Initial outlay($1100)
Revenues $1000Expenses 500
Cash flow $500
Revenues $2000Expenses 1000
Cash flow $1000
– $1100.00
+454.55
+826.45
+$181.00
1$500 x 1.10
1$1000 x 1.10
2
NPV
7-6Copyright 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?
YearDevelopment
Cost ($000)Returns ($000)
0 4201 320 2152 154 2253 4204 2405 160
8
Example: Continue• Before we proceed we must find the net
cash flows for each year
YearDevelopment
Cost ($000)Returns ($000)
Net Cash Flows
0 420 -4201 320 215 -1052 154 225 713 420 4204 240 2405 160 160
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 = 20.05• 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 = -8.64 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
7-12Copyright 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.
7-13Copyright 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 $ 50 2 100 3 150
Find the IRR such that NPV = 0
50 100 150 0 = –200 + + + (1+IRR)1 (1+IRR)2 (1+IRR)3
50 100 150 200 = + + (1+IRR)1 (1+IRR)2 (1+IRR)3
7-14Copyright 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 rates NPV
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
Year
Cash Flow
Depreciation
Taxation
Net Cash Flow
0 (100,000) (100,000) 1 68,000(1) 15,000(2) 21,200(3) 46,800 2 68,000 15,000 21,200 46,800 3 68,000 15,000 21,200 46,800 4 68,000 15,000 21,200 46,800 5 68,000 15,000 21,200 46,800 6 78,000(3) 15,000 21,200 56,800
Illustration:
20
• +/- 100000 Data• 46,800 Data• 46,800 Data• 46,800 Data• 46,800 Data• 46,800 Data• 56,800 Data• 2ndF CASH{CFi}• 20 ENT (interest
rate)• ▼ COMP• NPV = $58,982
• OR• +/- 100000 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:
7-21Copyright 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.
7-22Copyright 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.
7-23Copyright 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 forwhich the cash flows are as follows:
Year Cash flows
0 –$60
1 155
2 –100
7-24Copyright 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 projectNPV is calculated at various rates:
at 10%: NPV = -$1.74
at 20%: NPV = - 0.28
at 30%: NPV = 0.06
at 40%: NPV = - 0.31
Two questions:
1. What is going on here?
2. How many IRRs can there be?
NPV crosseszero
7-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan
NPV Profile