dcf n non dcf

8/3/2019 DCF n Non DCF

http://slidepdf.com/reader/full/dcf-n-non-dcf 1/36

COMPARATIVE ANALYSIS

OF DCF AND NON – DCFTECHNIQUES

Presented to : Dr. Paresh Shah

Presented by:

Sonal Nagpal (23)Nikita Porwal (27)

Bhawana Pokharna (36)

Priyanka Chaturvedi (38)



CAPITAL BUDGETING DECISIONS

Should webuild this

plant?




The investment decisions of a firm are generallyknown as the capital budgeting, or capitalexpenditure decisions.

The firm’s investment decisions would generallyinclude expansion, acquisition, modernisation andreplacement of the long-term assets. Sale of adivision or business (divestment) is also aninvestment decision.

Decisions like the change in the methods of salesdistribution, or an advertisement campaign or aresearch and development programme have long-term implications for the firm’s expenditures and

benefits, and therefore, they should also be evaluatedas investment decisions.



TYPES OF INVESTMENT DECISIONS

One classification is as follows:

Expansion of existing business

Expansion of new business

Replacement and modernisationYet another useful way to classify investments is asfollows:

Mutually exclusive investments

Independent investments



AN EXAMPLE OF MUTUALLY EXCLUSIVEPROJECTS

BRIDGE vs. BOAT to getproducts across a river.




These are generally:

Long-term decisions; involving large

expenditures.

Have long term consequences.

Difficult or expensive to reverse.



Capital BudgetingMethods

Discounting Criteria

NPV IRR PBP ARR

Non Discounting Criteria



NET PRESENT VALUE

NPV of a project is the sum of the present values ofall the cash flows positive as well as negative thatare expected to occur over the life of the project.

The formula for NPV is:

31 202 3

0

1

NPV(1 ) (1 ) (1 ) (1 )

NPV(1 )

nn

n

t

t

t

C C C C C

k k k k

C C

k



NET PRESENT VALUE

Where,

Ct = cash flow at the end of year t n = Life of the project

k = discount rate (given by the projects opportunitycost of capital which is equal to the required rate of

return expected by investors on investments ofequivalent risk).

C0 = Initial investment

1 / (1 + k )t = known as discounting factor or PVIF

i.e present value interest factor.



CALCULATING NET PRESENT

VALUE

Assume that Project X costs Rs 2,500 now and isexpected to generate year-end cash inflows of Rs900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1

through 5. The opportunity cost of the capital may beassumed to be 10 per cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

10)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225



ACCEPTANCE RULE OF NPV

Accept the project when NPV is positiveNPV > 0

Reject the project when NPV is negative

NPV < 0May accept or reject the project when NPV is zero

NPV = 0

( A project will have NPV = 0, only when the project generates cash inflows at a rate just equal to the opportunity cost of

capital )The NPV method can be used to select betweenmutually exclusive projects; the one with the higherNPV should be selected.



ADVANTAGES OF NPV METHOD

It considers time value of money.

It is a true measure of profitability as it uses the presentvalues of all cash flows (both outflows & inflows) &

opportunity cost as discount rate rather than any otherarbitrary assumption or subjective consideration.

The NPVs of individual projects can be simply added tocalculate the value of the firm . This is known as“Principle of value additivity ”.

It is consistent with the shareholders wealthmaximization principle as whenever a project withpositive NPV is undertaken, it results in positive cashflows and hence the increase in the value of the firm.



DISADVANTAGES OF NPV METHOD

It is difficult to estimate the expected cash flowsfrom a project.

Discount rate to be used is very difficult todetermine.

Since this method does not consider the life of theprojects, in case of mutually exclusive projects withdifferent life, the NPV rule, tends to be biased in

favour of the longer term project.

Since NPV is expressed in absolute terms ratherthan relative terms it does not consider the scale ofinvestment.



Profitability Index

An index that attempts to identify therelationship between the costs and benefits ofa proposed project through the use of a ratio

calculated as:

PI = Net Present Value * 100Cost of Asset

Asset with the highest PI is selected.



Acceptance rule

A ratio of 1.0 is logically the lowest acceptablemeasure on the index.

Any value lower than 1.0 would indicate that

the project's PV is less than the initialinvestment.

As values on the profitability index increase,

so does the financial attractiveness of theproposed project



INTERNAL RATE OF RETURN

METHOD

The internal rate of return (IRR) is the rate at which thediscounted net returns equal to the original investmenton the project.

This also implies that the rate of return is the discountrate which makes NPV = 0.

The formula for calculating IRR is:

31 2

0 2 3

0

1

0

1

(1 ) (1 ) (1 ) (1 )

(1 )

0

(1 )

n

n

n

t

t

t

n

t

t

t

C C C C C

r r r r

C C

r

C C

r



INTERNAL RATE OF RETURN

METHOD

Where,

Ct

= cash flow at the end of year t

n = Life of the project

r = discount rate

C0 = Initial investment

1 / (1 + r )t = known as discounting factor or PVIFi.e present value interest factor.



CALCULATION OF IRR

Uneven or non –normal Cash Flows:

Calculating IRR by Trial and Error

The approach is to select any discount rate tocompute the present value of cash inflows.

If the calculated present value of the expected cashinflow is lower than the present value of cashoutflows, a lower rate should be tried.

On the other hand, a higher value should be tried if

the present value of inflows is higher than the presentvalue of outflows.

This process will be repeated unless the net presentvalue becomes zero.



ACCEPTANCE RULE FOR IRR

Accept the project when r (IRR) > k (WACC).

Reject the project when r (IRR) < k (WACC).

May accept the project when r = k.

In case of independent projects, IRR and NPV rules willgive the same results if the firm has no shortage offunds.

In case of projects with equal IRR & different NPV,

select project with higher NPV as it is consistent withfirm’s wealth maximisation objective.



ADVANTAGES OF IRR METHOD

It considers time value of money.

It is a true measure of profitability as it uses thepresent values of all cash flows rather than any

other arbitrary assumption or subjectiveconsideration.

Whenever a project with higher IRR than WACCis undertaken, it results in the increase in the

shareholder’s return. Hence, the value of the firmalso increases.

The percentage figure generally allows a sound,uniform ranking of project.



PROBLEMS WITH IRR

It is not easy to understand and calculate the IRR as itinvolves complex and tedious computational problems.

There may be some investment projects on which noreal value of IRR can be computed, e.g. Socialprojects.The result shown by NPV and IRR may differ ifprojects are different in terms of

Expected life of project

Cash outlaysThe use of multiple rates might create confusion.



PAY BACK PERIOD

It is the number of years required to recover a project’s

cost, or how long does it take to get the business’s

money back?

10 8060

0 1 2 3

-100

=

CF

Cumulative -100 -90 50

Payback 2 + 30/80 = 2.375 years

0

100

2.4

-30



Strengths of Payback:

1. Provides an indication of a project’s risk and

liquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the time value of money.

2. Ignores CFs occurring after the payback period.

3. It is a measure of capital recovery & not

profitability.

PAY BACK PERIOD



DISCOUNTED PAYBACK PERIOD(DPBP)

10 8060

0 1 2 3

CFt

Cumulative -100 -90.91 -41.32 18.79

Discountedpayback 2 + 41.32/60.11 = 2.7 yrs

Discounted Payback: Uses discountedrather than raw CFs.

PVCFt -100

-100

9.09 49.59 60.11

=



ACCOUNTING RATE OF RETURNACCOUNTING RATE OF RETURN

The accounting rate of return is the ratio of the averageprofit after-tax divided by the average investment.

ARR = Average Profit After Tax *100

Average Investment

Where;

Average Investment = Initial Investment + Scrap Value

2A variation of the ARR method is to divide averageearnings after taxes by the original cost of the projectinstead of the average cost.



ACCEPTANCE RULE OF ARR

This method will accept all those projects whose ARR ishigher than the minimum rate established by themanagement and reject those projects which have ARRless than the minimum rate.

Accept if ARR > minimum rate.

Reject if ARR < minimum rate

This method would rank a project as number one if ithas highest ARR and lowest rank would be assigned tothe project with lowest ARR.



ACCOUNTING RATE OF RETURN

The ARR method has certain advantages as:

It is very simple to understand. This method takes into account all the profits

during the life time of the project, whereas payback period ignores the profits accruing afterthe pay back period .

Dependency on accounting data which isreadily available.

Shows the profitability of the project.



ACCOUNTING RATE OF RETURN

The disadvantages of ARR include: It is based on accounting profit rather than cash flows.

Time value of money is ignored.

This method does not account for the profits arising onsale of profit on old machinery on replacement.

ARR method does not consider the sizeof investment for each project.

It may be time that the competing ARR of two projectsmay be the same but they may require differentaverage investments. It becomes difficult for themanagement to decide which project should beimplemented.



CASE STUDY OF TREE HOUSE

EDUCATION IPO 2011

ASSUMPTIONS:

Cost of capital i.e. discount rate is 15%

Inflation rate for calculating future cash flows is

taken as 55%

Initial investment is assumed to be Rs 50million

The cash flow of year 2007 is taken as cashflow of 2012 and cash flow of year 2008 as2013 and so on....

C C O O



CALCULATION OF NET

PRESENT VALUE

YEAR NET CASH FLOW INFLATED CASH

FLOWS

DIS

FACTOR@15%

P.V OF C.F

2012 2.8 4.34 0.87 3.7758

2013 -1 -1.55 0.756 -1.1718

2014 19.66 30.47 0.657 20.01879

2015 81.98 127.06 0.571 72.55126

2016 175.27 271.67 0.497 135.01999

(Rs. In millions)



NPV OF CASH FLOW=230.19404(Rsmillion)

Therefore NPV of the project

= NPV Of Cashflow - Initial Investment

= 230.19404 – 50

=180.19404(Rs million)

CALCULATING THE



CALCULATING THE

PROFITABILITY INDEX

Profitability index= NPV/cost of assets * 100

=180.19/50 * 100

=360.38(%)

The NPV is positive and the profitability indexis more than unity. Hence the project may be

accepted.

CALCULATION OF THE



CALCULATION OF THE

PAYBACK PERIOD

YEAR INFLATED CASH

FLOWS

2012 4.34 2013 -1.55 2014 30.47 2015 127.06 2016 271.67

Payback period= 4.34 + (-1.55) + 30.47 + 16.47

= 50million.

That is 3 years + (16.47*12)/127.06

= 3years + 48 days

=36 months and 48 days.



CONCLUSION

From the above study, we can conclude thatDCF is a better technique than NON DCF.

As DCF technique considers the time value of

money which is a very important factor. On the basis of time value you can consider

the future value and discount them and judge

whether to invest or not on the basis of NPV ofa project.



While in NON-DCF, time value factor is nottaken which is a disadvantage.

It does not take into account any discount

factor. On the basis of payback period also youcannot judge the value of firm.

Cashflows after the payback period are not

taken into consideration which does not let youknow the over all return on investment and theprofitability.

dcf n non dcf

Documents