4 methods in DCF

1. NPV Steps
- Use Cashflows - Find the cashflows(Initial, Operating, Terminal)

- Use Time value of money - Discount them to time t = 0

- Find PV of Cash inflows - PV of Cash outflows
- NPV > 0 , accept else reject

2. IRR Discount Rate at which NPV = 0

- Use Cashflows - Find the cashflows(Initial, Operating, Terminal)
- Use Time Value of money - Use IRR formula to find IRR
- Manually IRR can be found only if cashflows are uniform(Annuity)
- If IRR > Req rate of return, accept else reject
3. Payback - Discounted Payback
- Use Cashflows - Use cashflows
- Ignores Time value of money - Use Time value of money
Gives a time period measure, hence LIQUIDITY
Does not account for cashflows after payback
Profitabality is ignored
Always, Discounted PB > PB
4. ARR or ROI Accounting Rate of Return
ARR = Net Profit/Net InvestmenSimple, gives a measure of profitability
5. Profitability Index Formula
PV of Cashinflows/PV of Cashoutflows

IRR Formula in case of Annuity

PV Factor = Initial investment/Annuity

Payback = Initial investment/Annuity

If there are perpetual cashflows(till infinity)

Payback Reciprocal = IRR
IRR = 1/payback period
NPV IRR
Mom Girlfriend
Dad Boyfriend
Percentage value and hence size
Expressed in Dollar value effect ignored
Value accretion can be clearly found IRR may not give those details
Can be used if discount rate varies Cannot use IRR
NPV assumes cashflows are re-invested IRR assumes cashflows are re-invested
@ req rate of return(Discount rate) @ IRR
NPV of diff proj can be summed up Cannot sum IRRs

NPV > 0 IRR > Req rate of return PI > 1

NPV < 0 IRR < Req rate of return PI < 1
NPV = 0 IRR = Req rate of return PI = 1
Both NPV and IRR will give SAME accept/reject decisions
But, NPV and IRR may differ while RANKING different projects
Reasons
1. Cashflows are inconsistent

Connection points
- IRR and Payback are going to use same formula
- NPV and PI require same inputs
- ROI is unique
IRR using manual method
Initial outlfow Uniform Cash inflows rate = 8%
Yr 0 1 2 3 NPV 1540
-50000 20000 20000 20000

- @ IRR, NPV = 0
so 20000 of annuity is multiplied by a PV factor such that PV is 50000
PV factor 2.5 - Cashoutflow/Uniform cash inflow
Period is 3 yrs
From the chart, we can find that IRR is between 9% and 10%

NPV Profile Variation of NPV wrt changes in discount rate

How to plot
For each project find these 2 points
Y intercept Find NPV @ 0% discount rate
- Sum of undiscounted cashflows
X intercept IRR
Years 2020 2021 We should be able to do below
Actual Revenues 100 105 Nominal Cashflows 1. Convert nominal to real cash
2. Convert real to nominal cash
Year on year growth = 5% Nominal Growth Rate 3. Convert nominal to real rate
Units Sold 20 19 4. Convert real to nominal rate
SP/unit 5 5.5

The Inflation in 2021 is 10% (1+Nominal Growth rate) = (1+Real Growt

LHS 105%
Years 2020 2021 RHS 105%
Revenues adj for Inflation 100 95.5 Real Cashflows

Year on year growth = -4.5% Real Growth Rate

If you are using real cashflows for capital budgeting, the discount rate should be adjusted for inflation ie no inflation in the dis
If you are using nominal cashflows for capital budgeting, discount rate should not be adjusted for Inflation ie Inflation should b
 We should be able to do below 4
1. Convert nominal to real cashflows. -----> Divide nominal cashflows by (1+Inflation rate)
2. Convert real to nominal cashflows. ------> Multiply by (1+Inflation rate)
3. Convert nominal to real rate of return
4. Convert real to nominal rate of return

al Growth rate) = (1+Real Growth rate) * (1+Inflation Rate)

nflation ie no inflation in the discount rate

for Inflation ie Inflation should be part of discount rate
Capital Rationing Maximize NPV of the limited Capital

Ranking To rank is the objective

PI Same concept of NPV and extension of NPV
Formula PV of cash inflows/PV of cash outflows
1 + NPV/CF0

Mutually exclusive projects Only one of the available options can be chosen
Always prefer NPV
These projects are dependent - If one is chosen, other cannot be chosen

Independent Projects
Unrelated projects

Other Methods of Ranking

Linear Programming Objective equation Maximize NPV
Constraints Ex: Capital rationing
Find the best investment strategy - Amt to be invested in each proj

Internal Capital markets

One division can provide money to other divisions
 PV of cash outflows PV of cash inflows NPV PI
Proj A 20 30 10 1.5
Proj B 100 115 15 1.15

Cash outflows NPV PI Ranks

A ($2,400) $450 1.1875 4
B ($1,400) $300 1.2143 1
C ($1,000) $200 1.2000 2
D ($1,200) $230 1.1917 3
Assume you have only $3600 as capital
Best Possible combinations
AB 750
AC 650
AD 680
BCD 730
Going by ranks, you will choose B,C, D but that is not the right strategy
To select the best combination of Projects, maxime NPV of the combination
Sensitivity analysis
What if - Change an input variable to study the change in output
Ex: NPV profile

Scenarios
Change more than 1 independent variable to get different scenarios

Simulation
Model of real time environment where actual behavioral changes can be studied
- Run the simulation for 10 times and plot NPV in a frequency distribution graph
- Statistical models to evaluate different results
- Monte Carlo Simulation
Discount rate
Certainty equivalent Risk free rate
Remove risks for cashflows and use risk-free rate to find NPV Nominal rate
Only 2 steps differ from normal NPV Real rate
1. Multiplying cashflows by certainty factors
2. Discounting by rf which is my risk free rate

Use of specially adjusted rates

Adjust discount rate for project specific risks
Cashflows
Risk free cashflows
Nominal Cashflows
Real cashflows
Question 1 Initial 150000

Question 2

1 2 3 4 5
Outflow -200000 -200000 -200000 -200000 -200000
Tax Savings 80000 80000 80000 80000 80000
Net outflow -120000 -120000 -120000 -120000 -120000
PV(10%, 5 yyrs) 3.790787 3.791
PV of outflows -454894 -454920

Question 9

NPV Annuity 6000000 IRR NPV = 0

years 12 PV Of inflows = PV of outflows
WACC 14% PV of inflows = 40000000
PV factor 5.66 PV of inflows = PV factor * Annuity
PV Factor = PV Of inflows/Annuity
PV of inflo 33960000 PV Factor = 40000000/6000000
NPV -6040000 Rate at 12 yyears and PV factor = 6.66
Sales Prob
80000 0.1
85000 0.2
90000 0.3
95000 0.2
100000 0.1
110000 0.1

Expected val of Sales 92000 units

0 1 2 3 4 5
Initial inv -1000000
Units sold 92000 92000 92000 92000 92000
Prof Margin /unit 5 5 5 5 5
Profits 460000 460000 460000 460000 460000
PAT 276000 276000 276000 276000 276000
Depreciation 200000 200000 200000 200000 200000
DTS 80000 80000 80000 80000 80000

Operating cashflow 356000 356000 356000 356000 356000

FCFF -1000000 356000 356000 356000 356000 356000

PV factor for annuity 3.605
PV of inflows 1283380
NPV 283380
 0 1 2 3 4 5
Init Investment -43000
CF 18000 14400 12600 10800 9000
CE 95% 90% 80% 75% 50%
Certain cashflows 17100 12960 10080 8100 4500
PV factors 0.962 0.925 0.889 0.855 0.822
PV of inflows 16450.2 11988 8961.12 6925.5 3699

NPV 5024
 WACC 10%
Proj X Proj Y
PV factor 3.790787 0.620921
PV of inflows 178167 173858
NPV 28166.98 23857.97

ows = PV of outflows
ws = 40000000
ws = PV factor * Annuity
= PV Of inflows/Annuity
= 40000000/6000000 6.666667
yyears and PV factor = 6.66 10%
WACC Tax
12% 40%
Rf 4%
0.961538
0.924556
0.888996
0.854804
0.821927
Alternative 1
0 2007 2008 2009 2010
Sale proceeds from plant 3000000
Tax saved on CL(inflow) = 240000
NPV = 3240000

Alternative 2
0 2007 2008 2009 2010
Lease Payments 1020000 1020000 1020000 1020000
Lease income after tax 612000 612000 612000 612000
Depreciation 900000 900000 900000 900000
DTS 360000 360000 360000 360000
MV of asset(end of life) 600000
Tax on CG/CL = 0
Final CFs = 972000 972000 972000 1572000
NPV = 3051206

Alternative 3
0 2007 2008 2009 2010
Sales 4200000 4200000 4200000
Annual cash outlay 2250000 2250000 2250000
Profit -2250000 1950000 1950000 4200000
Profit after tax -1350000 1170000 1170000 2520000
Depreciation 900000 900000 900000 900000
DTS 360000 360000 360000 360000
MV of asset(end of life) 600000
Tax on CG/CL = 0
Final Cash Flow -990000 1530000 1530000 3480000
NPV = 3185770
 BV of plant as of 1-1-07 = 4200000
Sales value of plant = 3000000
Capital Loss = 1200000
Tax saved on CL(inflow) = 240000

EV of Sales 5200000
BV of Asset at end of 2010 600000
MV at end of 2010 = 600000
CG or CL = 0
Hurdle Rate or Cost of Capital = 10%
Project A
0 1 2 3 4 5
-155000 43000 43000 43000 43000 43000
IRR = 12.00%

Project B
0 1 2 3 4 5
-240000 60000 60000 60000 60000 60000
IRR = 7.93%

By Manual Method
PV Factor Proj A = 3.605 IRR of Proj A = 12% Greater than Cost of Capital, hence ACCEPT
PV Factor Proj B = 4 IRR of Proj B = 8% less than Cost of Capital, hence REJECT

Payback Method
Payback for A 3.605 yrs ACCEPT because this is < 4yrs
Payback for B 4.000 yrs ACCEPT because this is = 4yrs which Company requirement
 BV Market ValueCG/CL Tax paid/saved
Land 500000 700000 200000 -80000
Building 1000000 800000 -200000 80000
Equipment 0 120000 120000 -48000
Tax rate 40% Revenues 1500000
Discount rate 6%
0 1 2 3 4 5
Land -500000
Building -2000000
Equipment -3000000
ICF -5500000
Revenues 1500000 1500000 1500000 1500000 1500000
Cash expenses 300000 300000 300000 300000 300000
Pretax profit 1200000 1200000 1200000 1200000 1200000
After tax profit 720000 720000 720000 720000 720000
Depreciation of Building 200000 200000 200000 200000 200000
Depreciation of Equipment 600000 600000 600000 600000 600000
Total Depreciation 800000 800000 800000 800000 800000
DTS 320000 320000 320000 320000 320000
OCF 1040000 1040000 1040000 1040000 1040000

Sale value of Land 700000

Sale value of Building 800000
Sale value of Equipment 120000
Tax paid on Cap Gains on Land -80000
Tax saved on Cap Loss on Building 80000
Tax paid on Cap Gains on Equipment -48000
TCF 1572000

Final Cashflows -5500000 1040000 1040000 1040000 1040000 2612000

NPV 55548.18 ACCEPT
IRR 6.321% ACCEPT
Option C
 Projects Investment NPV PV of inflowPI
Project A ($2,400) $450 $2,850 1.19
Project B ($1,400) $300 $1,700 1.21
Project D ($1,200) $230 $1,430 1.19
Project C ($1,000) $200 $1,200 1.20

NPV
ABC 950
ABD 980
ACD 880
BCD 730

Intial inv PV of inflowNPV PI

A 5000 5500 500 1.10
B 6000 6500 500 1.08

Volvo 0 1 2
NPV 2 mn
0 1 2
2 mn
Total NPV 3.594

Benz 0 1 2 3 4
NPV 3.5 mn
Proj A 0 1 2 3 4 5 6
-1000 1000 1000 1000
1321.63

Proj B 0 1 2 3 4 5 6
-1000 0 0 0 1500 1500 1500
1350.55

1350.93 2350.926 3483

Project A
Year Exp. cashfl CE factor Discount Factor @ 3% Certain cashPV
1 1,500 0.9 0.971 1350 1310.85
2 1,200 0.85 0.943 1020 961.86
3 900 0.7 0.915 630 576.45
4 600 0.6 0.888 360 319.68
Initial Investment - 3,000; Risk free rate 3%; Calculate Project’s NPV

NPV 168.84

Prize money 100

Prob of winning 0.50

Expected value 50 Which is CE

 Proj A 0 1 2 3 4 5 6
-1000 1000 1000 1000

Proj B 0 1 2 3 4 5 6
-1000 0.0 0.0 0.0 1500 1500 1500
We can solve this
problem without
finding NPV at all OR

Proj B 0 1 2 3 4 5 6
-1000 1012.5 1012.5 1012.5