Discounted Cash Flow Additional Clarification

11 March 2014

Background
A number of students have had very limited exposure to the concepts behind discounted cash flow in their past A number of students do not use spreadsheets regularly It became clear in the exam prep/Q&A session that some students were experiencing difficulty understanding the concepts This short presentation will use one of the past exam questions to go through the calculations NOT the additional analysis required to answer the remainder of the question.

Basic Concepts
See Collier (4th edition ) Chapter 14. Money now is worth more than money in the future. A future cash flow is worth less (in todays money) than if the cash flow occurred now.
Money in hand now could be invested at current interest rates. Eg $100 invested now at an annual interest rate of 10% is equivalent to $110 (100+ 10% of 100) in 1 years time and $121 (110 +10% of 110)in 2 years time. Similarly $100 in one years time is equivalent to $91 now using the same interest rate

Discounted cash Flow discounts future cash flow to their present value equivalent. The discount factor can be derived from: a pre calculated table (page 289 Collier 4th edition) calculated directly Using a pre set up spreadsheet The formula for a discount factor is 1/ (1+r)n where r is the interest rate and n in the number of periods in the future. Eg. The NPV discount factor for a cash flow in 2 years with an interest rate of 10% would be 1/(1+0.1)2 = 1/1.21 = 0.8264

Q7 2013
Investment Appraisal (15%) A fashion company is considering expanding its product line and to do this it will need to invest in some new equipment. The equipment is priced at $440,000 and has a life of 5 years. Unit Sales of the new product are anticipated to be: Units 10,000 15,000 20,000 20,000 20,000

Discount table for use with the above question

Year 1 Year 2 Year 3 Year 4 Year 5

Present Value Factors

Years 1 5% 0.952 0.907 0.864 0.823 0.747 10% 0.909 0.826 0.751 0.683 0.621 15% 0.870 0.756 0.658 0.572 0.497 20% 0.833 0.694 0.579 0.482 0.402

The target selling price per unit is $20 and the estimated variable cost per unit (manufacturing, sales and distribution) is $12. For simplicity assume all cash flows are at year end. The company currently has a hurdle rate of return of 15%. a) Calculate the net present value of the cash flows associated with the investment. b) The company is negotiating a discount on the equipment. What is the maximum price the company should pay if it is to meet the 15% hurdle rate of return on the project, based on the above assumptions? c) Which other factors should the company take into account when making the investment decision? Why should it consider these factors?

2 3 4 5

Calculations
Cash flows from info provided (in $,000)

Year 0 (investment) 1 2 3 4 5 Total

Cash Flow -440 80 120 160 160 160

Discount factor (15%)

NPV -440.00

0.870 0.756 0.658 0.572 0.497

69.60 90.72 105.2 91.52 79.52 -3.44

Using table on exam question 3 decimal places a) The calculation shows a Net Present Value for the investment of $ -3,440 (-3,470) I.e. it fails to meet the hurdle rate of 15%.

Interest Rate Project 1 Description Investment Expenditure income/expense income/expense income/expense income/expense income/expense income/expense income/expense income/expense income/expense NET PRESENT VALUE

15.00%

Year 0 1 2 3 4 5

Cash Flow Discount Present Factor Value -440 1.0000 -440.00 80 0.8696 69.57 120 0.7561 90.74 160 0.6575 105.20 160 0.5718 91.48 160 0.4972 79.55 1.0000 0.00 1.0000 0.00 1.0000 0.00 1.0000 0.00 -3.47

b) If the price for the equipment could be negotiated down by at least $3,440 (3,470) the investment would show a zero/positive NPV at the hurdle rate of 15%. NPV at other interest rates could be calculated to show sensitivity. IRR could be calculated to show actual rate of return (easiest with spreadsheet) Using spreadsheet 4 decimal places
5