You are on page 1of 7

1

STUDY UNIT EIGHTEEN


DISCOUNTED CASH FLOW AND PAYBACK

18.1 Discounted Cash Flow Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1


18.2 Payback and Discounted Payback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
18.3 Core Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

This study unit is the second of four on investment decisions. The relative weight assigned to
this major topic in Part 3 of the exam is 20% at skill level C (all six skill types required). The four
study units are
Study Unit 17: The Capital Budgeting Process
Study Unit 18: Discounted Cash Flow and Payback
Study Unit 19: Ranking Investment Projects
Study Unit 20: Risk Analysis and Real Options
After studying the outlines and answering the multiple-choice questions, you will have the skills
necessary to address the following topics listed in the IMA’s Learning Outcome Statements:
Part 3 – Section E.2. Discounted cash flow analysis
The candidate should be able to:
a. demonstrate an understanding of the two main DCF methods, net present value (NPV) and
internal rate of return (IRR)
b. demonstrate an understanding of the weighted average cost of capital approach to NPV
calculations
c. calculate the NPV and IRR using time value of money tables
d. demonstrate an understanding of the decision criteria used in NPV and IRR analyses to
determine acceptable projects
e. compare NPV and IRR
f. identify assumptions of the different methods of evaluating capital investment projects
g. recommend project investments on the basis of DCF analysis
Part 3 – Section E.3. Payback and discounted payback
The candidate should be able to:

a. demonstrate an understanding of the payback method


b. identify the advantages and disadvantages/limitations of the payback method
c. calculate payback periods and discounted paybacks
d. evaluate and recommend investment projects on the basis of discounted payback analysis

18.1 DISCOUNTED CASH FLOW ANALYSIS

1. The goal of managers in making capital budgeting (long-term funding) decisions is to


increase the value of the firm and thus increase shareholders’ wealth.
a. Two concepts are central to the use of discounted cash flow (DCF) analysis in
making investment decisions: the firm’s cost of capital and the time value of money.

1) In general, investments with a return higher than the firm’s cost of capital will
increase the value of the firm.
2) See item 3. under subunit 8.3 for a discussion of discounting and the time
value of money.

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
2 SU 18: Discounted Cash Flow and Payback

b. Two principal methods are in use for comparing the projected return on an investment
with the company’s cost of capital: net present value and internal rate of return.
2. The net present value (NPV) method calculates the present value of all expected cash
streams (both inflows and outflows) related to a project and nets them.
a. The discount rate is the company’s desired rate of return, also called the hurdle rate
(generally the company’s weighted average cost of capital; see subunit 9.1).
1)If the NPV of a project is positive, the project is desirable because it has a
higher rate of return than the company’s desired rate.
b. EXAMPLE:
1) A company is considering investing in a project that is expected to bring in the
cash flows presented in the table below. Each year’s expected cash flow is
discounted based on the present value of $1 at the company’s desired rate of
return, which is 8%. After the eighth year, the project’s output will be
completely obsolete.
Present Value Present Value of
End of Year Cash Inflow Factor Cash Stream
Year 1 $ 0 0.926 $ 0
Year 2 800,000 0.857 685,600
Year 3 2,000,000 0.794 1,588,000
Year 4 4,000,000 0.735 2,940,000
Year 5 4,000,000 0.681 2,724,000
Year 6 2,000,000 0.630 1,260,000
Year 7 2,000,000 0.583 1,166,000
Year 8 1,000,000 0.540 540,000
Total discounted cash inflows $10,903,600

2) The project will require an outlay of $10,000,000 immediately and another


$2,000,000 at the beginning of the fourth year.
Beginning Present Value Present Value of
of Year Cash Outflow Factor Cash Stream
Year 1 $10,000,000 1.000 $10,000,000
Year 2 0 0.926 0
Year 3 0 0.857 0
Year 4 2,000,000 0.794 1,588,000
Year 5 0 0.735 0
Year 6 0 0.681 0
Year 7 0 0.630 0
Year 8 0 0.583 0
Total discounted cash outflows $11,588,000

3) The project’s net present value is calculated as follows:


Total discounted cash inflows $10,903,600
Total discounted cash outflows (11,588,000)
Net Present Value $ (684,400)

The project’s negative net present value indicates that it has a lower rate of
4)
return than the company’s desired rate and thus should be rejected.
3. The internal rate of return (IRR) is the discount rate that sets the NPV of an investment
equal to zero, i.e., the rate that makes the present value of the expected cash inflows equal
the present value of the expected cash outflows.
If the IRR is higher than the company’s desired rate of return, the investment is
a.
desirable.

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
SU 18: Discounted Cash Flow and Payback 3

b. EXAMPLE:
1) In the project described on the previous page, the use of 8% as the discount rate
clearly does not cause the cash streams to be equal.
2) Because the discounted cash inflows are lower than discounted cash outflows,
the inflows must be recalculated using a lower discount rate. Here is the new
computation using 7%:
Present Value Present Value
End of Year Cash Inflow Factor of Cash Stream
Year 1 $ 0 0.935 $ 0
Year 2 800,000 0.873 698,400
Year 3 2,000,000 0.816 1,632,000
Year 4 4,000,000 0.763 3,052,000
Year 5 4,000,000 0.713 2,852,000
Year 6 2,000,000 0.666 1,332,000
Year 7 2,000,000 0.623 1,246,000
Year 8 1,000,000 0.582 582,000
Cash inflows discounted at 7% $11,394,400

3) At 7%, the discounted cash inflows ($11,394,400) are still less than the
discounted cash outflows ($11,588,000). Here are the cash inflows discounted
at 6%:
Present Value Present Value
End of Year Cash Inflow Factor of Cash Stream
Year 1 $ 0 0.943 $ 0
Year 2 800,000 0.890 712,000
Year 3 2,000,000 0.840 1,680,000
Year 4 4,000,000 0.792 3,168,000
Year 5 4,000,000 0.747 2,988,000
Year 6 2,000,000 0.705 1,410,000
Year 7 2,000,000 0.665 1,330,000
Year 8 1,000,000 0.627 627,000
Cash inflows discounted at 6% $11,915,000

4) At 6%, the discounted cash inflows are greater than the discounted cash
outflows. The project thus has an internal rate of return between 6% and 7%.
Because the company’s desired rate of return is 8%, the project should be
a)
rejected, the same decision that was arrived at using the net present
value method.
c. Multiple IRR solutions. Under some circumstances, the IRR is not totally reliable
because it can give multiple answers for the same set of facts. This anomaly occurs
when more than one change in the direction of net periodic cash flows occurs.
1) For example, one direction change occurs when an initial net cash outflow is
followed by a series of net inflows. However, if a negative net cash flow occurs
in a later period, another direction change and a second solution result. The
number of solutions to the IRR formula equals the number of changes in the
direction of the net cash flows.
a) The IRR equation has multiple roots (solutions). However, all of these
roots except one are imaginary numbers when one change in the
direction of cash flows occurs. If more than one direction change occurs,
the number of real roots increases on a one-to-one basis.

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
4 SU 18: Discounted Cash Flow and Payback

For example, an investment in a nuclear reactor requires an initial outflow


b)
of funds at the time of acquisition. This outflow is followed by years of
inflows. Then, at either periodic intervals or at the end of the asset’s life,
substantial outflows will be necessary for cleanup costs (perhaps greater
than the initial purchase cost). This change in direction of cash flows
causes the IRR multiple-solution problem.
d. An improved version of the IRR is the modified IRR (MIRR). It assumes that
reinvestment is at the desired rate of return rather than at the IRR.
4. Comparing NPV and IRR.
a. The reinvestment rate becomes critical when choosing between the NPV and IRR
methods. NPV assumes the cash flows from the investment can be reinvested at
the particular project’s discount rate, that is, the desired rate of return.
b. The NPV and IRR methods give the same accept/reject decision if projects are
independent. Independent projects have unrelated cash flows. Hence, all
acceptable independent projects can be undertaken.
1) However, if projects are mutually exclusive, the NPV and IRR methods may
rank them differently if
a) The cost of one project is greater than the cost of another.
b) The timing, amounts, and directions of cash flows differ among projects.
c) The projects have different useful lives.
d) The cost of capital or desired rate of return varies over the life of a
project. The NPV can easily be determined using different desired rates
of return for different periods. The IRR determines one rate for the
project.
e) Multiple investments are involved in a project. NPV amounts are
addable, but IRR rates are not. The IRR for the whole is not the sum of
the IRRs for the parts.
2) The IRR method assumes that the cash flows will be reinvested at the internal
rate of return.
If the project’s funds are not reinvested at the IRR, the ranking calculations
a)
obtained may be in error.
b) The NPV method gives a better grasp of the problem in many decision
situations because the reinvestment is assumed to be in the desired rate
of return.
c. NPV and IRR are the soundest investment rules from a shareholder wealth
maximization perspective.
1) In some cases, NPV and IRR will rank projects differently.
a) EXAMPLE:
Project Initial Cost Year-End Cash Flow IRR NPV (k=10%)
A $1,000 $1,200 20% $91
B $ 50 $ 100 100% $41

i) IRR preference ordering: B, A


ii) NPV preference ordering: A, B
d. If one of two or more mutually exclusive projects is accepted, the others must be
rejected.
1) EXAMPLE: The decision to build a shopping mall on a piece of land eliminates
placing an office building on the same land.

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
SU 18: Discounted Cash Flow and Payback 5

2) When choosing between mutually exclusive projects, the ranking differences


between NPV and IRR become very important. In the example 4.c.1), a firm
using IRR would accept B and reject A. A firm using NPV would make exactly
the opposite choice.
e. The problem can be seen more clearly using a net present value profile. The NPV
profile is a plot of a project’s NPV at different discount rates. The NPV is plotted on
the vertical axis and the rate of return (k) on the horizontal axis.

1) These profiles are downward sloping because a higher discount rate (desired
rate of return) implies a lower NPV. The graph shows that, for all discount rates
higher than k*, the firm should select project B over A because NPVB is greater
than NPVA. This preference ordering also results from applying the IRR
criterion. Below k*, however, NPVA is greater than NPVB, so A should be
selected, even though IRRB is greater than IRRA.
2) These profiles show that IRR will always prefer B to A. NPV will prefer B to A
only past some critical discount rate k*.
f. The manager concerned with shareholder wealth maximization should choose the
project with the greatest NPV, not the largest IRR. IRR is a percentage measure of
wealth, but NPV is an absolute measure. Shareholder well-being is also measured in
absolute amounts.
1) The choice of NPV over IRR is easy to see with a simple example. Assume a
choice between investing $1 and receiving $2 or investing $100,000 and
receiving $150,000. The IRRs of the projects are 100% and 50%, respectively,
which supports the first project. But assume instead that the interest rate is
10%. The NPVs of the projects are $.81 and $36,363, respectively. To select
the first project because of the IRR criterion would lead to a return of $.81
instead of $36,363. Thus, the NPV is the better criterion when choosing
between mutually exclusive projects.
g. The NPV profile can be of great practical use to managers trying to make investment
decisions. It gives the manager a clear insight into the following questions:
1) At what interest rates is an investment project still a profitable opportunity?
2) How sensitive is a project’s profitability to changes in the discount rate?

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
6 SU 18: Discounted Cash Flow and Payback

18.2 PAYBACK AND DISCOUNTED PAYBACK


1. The payback period is the number of years required to return the original investment; that
is, the time necessary for a new asset to pay for itself. Note that no accounting is made
for the time value of money under this method.
a. Companies using the payback method set a maximum length of time within which
projects must pay for themselves to be considered acceptable.
b. If the cash flows are constant, the formula is

1) EXAMPLE: A project is being considered that will require an outlay of $200,000


immediately and will return a steady cash flow of $52,000 for the next four
years. The company requires a 4-year payback period on all capital projects.
a)Payback period = $200,000 ÷ $52,000 = 3.846 years
b)The project’s payback period is less than the company’s maximum and the
project is thus acceptable.
c. If the cash flows are not constant, the calculation must be in cumulative form.
1) EXAMPLE: Instead of the smooth inflows predicted above, the project’s cash
stream is expected to vary. The payback period is calculated as follows:
Remaining Initial
End of Year Cash Inflow Investment
Year 0 $ 0 $200,000
Year 1 48,000 152,000
Year 2 54,000 98,000
Year 3 54,000 44,000
Year 4 42,000 2,000

At the end of four years, the original investment has still not been
a)
recovered, so the project is rejected.
d. The strength of the payback method is its simplicity.
1) The payback method is sometimes used for foreign investments if foreign
expropriation of firm assets is feared. Even in these circumstances, it is most
often used in addition to a more sophisticated method.
2) To some extent, the payback period measures risk. The longer the period, the
more risky the investment.
e. Related payback methods
1) The discounted (present value) payback method uses discounted cash flows
in the denominator to calculate the period required to recover the initial
investment. This is a more conservative technique than the traditional payback
method.
2) The bailout payback method incorporates the salvage value of the asset into
the calculation. It measures the length of the payback period when the periodic
cash inflows are combined with the salvage value.
3) The payback reciprocal (1 ÷ payback) is sometimes used as an estimate of the
internal rate of return.

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com
SU 18: Discounted Cash Flow and Payback 7

4) The breakeven time is the period required for the discounted cumulative cash
inflows on a project to equal the discounted cumulative cash outflows (usually
but not always the initial cost).
a) Thus, it is the time necessary for the present value of the discounted cash
flows to equal zero. This period begins at the outset of a project, not
when the initial cash outflow occurs.
b) An alternative that results in a longer breakeven time is to consider the
time required for the present value of the cumulative cash inflows to equal
the present value of all the expected future cash outflows.

18.3 CORE CONCEPTS


Discounted Cash Flow Analysis
s
The goal of managers in making capital budgeting (long-term funding) decisions is to
increase the value of the firm and thus increase shareholders’ wealth.
s
Two principal methods are in use for comparing the projected return on an investment with
the company’s cost of capital: net present value and internal rate of return.
s
The net present value method calculates the present value of all expected cash streams
(both inflows and outflows) related to a project and nets them. The discount rate is the
company’s desired rate of return, also called the hurdle rate (generally the company’s
weighted average cost of capital). If the NPV of a project is positive, the project is desirable
because it has a higher rate of return than the company’s desired rate.
s
The internal rate of return is the discount rate that sets the NPV of an investment equal to
zero, i.e., the rate that makes the present value of the expected cash inflows equal the
present value of the expected cash outflows.
s
The NPV and IRR methods give the same accept/reject decision if projects are
independent. However, if projects are mutually exclusive, the NPV and IRR methods may
rank them differently. This could be the outcome if, for instance, the cost of one project is
greater than the cost of another, or the projects have different useful lives.
s
The manager concerned with shareholder wealth maximization should choose the project
with the greatest NPV, not the largest IRR. IRR is a percentage measure of wealth, but
NPV is an absolute measure.
Payback and Discounted Payback

s
The payback period is the number of years required to return the original investment; that
is, the time necessary for a new asset to pay for itself. Note that no accounting is made for
the time value of money under this method.
s
If the cash flows are constant, the formula is payback period = initial net investment ÷
annual expected cash flow.
s
If the cash flows are not constant, the calculation must be in cumulative form. Each cash
inflow is successively subtracted from the initial investment. The number of years until $0
is reached is the payback period.
s
Other payback methods include discounted payback, bailout payback, payback reciprocal,
and breakeven time.

Copyright © 2006 Gleim Publications, Inc. and/or Gleim Internet, Inc. All rights reserved. Duplication prohibited. www.gleim.com