Group 4

Group Introduction

BCSF22M003 Mahnoor Ishaq

BCSF22M005 Faiza Gull
BCSF22M031 M . Junaid Malik
BCSF22M038 Zainab Mehmood
BCSF22M057 Muhammad Bin Muneer
Assessing Investment
Proposals
 Capital Investment Decision-Making using Discounted
Cash Flow (DCF)
1. Introduction:
• Companies face competition for limited investment resources.
• Capital selection requires careful consideration, often using discounted cash
flow.
2. Assessment Criteria:
• Factors include alignment with long-term plans, risk evaluation, and resource
availability.
• Financial return is a key criterion, assessed through Discounted Cash Flow
(DCF).
3. Discounted Cash Flow (DCF) Concept:
• Discounted Cash Flow helps us figure out how much money in the future is
worth in today's terms, considering the opportunity to earn more with that money
now.
• Formula: X/where r is the cost of capital expressed as a fraction, t is time(typically
in years).
 4. Investment Essence:
• You are paying a price now to get something valuable in return later.
• Net Present Value (NPV) is crucial, calculated as the sum of present values
of annual cash flows.
5. Net Present Value (NPV) Calculation:
• NPV formula: ​, considering project life (n) and cash flow in each year (Xi​).
6. Handling Inflation:
• Inflation effects are accounted for in predicting future cash flows within the
DCF analysis.
7. Alternative Analysis with Inflation:
If assuming no change in general price levels:
• Cost of capital should be adjusted using (m − i) / (m + i).
(Where m is the monetary cost of capital, and i is the inflation rate.)
 DCF Analysis For Product Development (Example):
Year 0 1st 2nd 3rd 4th
Development £60000 £30000 £0 £0 £0
Cost
Maintenance £0 £20000 £20000 £20000 £5000

Sales and £10000 £20000 £20000 £20000 £5000

Marketing
Number of 0 15 30 30 10
Sales
Revenue £0 £60000 £120000 £120000 £40000
Net Cash Flow -£70000 -£10000 £80000 £80000 £30000

Discount factor 1 0.909 0.826 0.751 0.683

Present value -£70000 -£9091 £66116 £60105 £20490

Cumulative -£70000 -£79091 -£12975 £47130 £67620

Present Value
 Important Facts Deduced from the Table:

NPV: £67,620 over five years.

Pay-back period: Four years.(Cumulative Present Value becomes positive
in the 4th year)
IRR(Internal Rate of Return): The cost of capital resulting in a zero NPV.
​= 0

(The IRR which is the maximum cost of capital at which the project would be viable
for this is 40.5% and cannot be deduced directly.)
 Decision Criteria and Sensitivity Analysis in DCF)
1. Decision Criteria:
Proposal rejection criteria:
• Negative NPV.
• Pay-back period exceeding a set threshold.
• IRR below the current cost of capital.

2. Selection Priority:
• If choices persist, prioritize projects with the highest positive NPV.
• Companies may opt for projects with higher IRRs or shorter pay-back periods
due to other pressures.

3. Caution in DCF Analysis:

While DCF offers precision, inherent uncertainty in cash flow predictions exists.
Assessing uncertainty varies:
1. Replacement of plant or equipment in stable industries.
2. Development of software products involves greater uncertainty.
 4. Sources of Uncertainty in Software Development:
• Potential resource overruns.
• Delayed market readiness.
• Unpredictable sales patterns.
• Competition from other products.

5. Sensitivity Analysis:
• Conduct multiple DCF analyses with varied cash flow and discount rate estimates.
• Assess project sensitivity to changes.
• If the project remains attractive under various assumptions, it is comparatively low risk.
• If unattractive under small changes, it is high risk and warrants reconsideration.

6. Example Sensitivity:
• In the given software development case, a drop in sales in years 2, 3, and 4 renders
cash flow never positive.
• Sensitivity analysis helps identify high-risk scenarios for informed decision-making.
 THE END
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