Finance

Exam NO. B023549 Tutor Mr.Henri Aitken 08/03/2012

Finance

Nowadays a correct decision in business world means wealth. Money is desired and techniques to choose the best option what to invest in have been developed. Purpose of this essay it to look at the modes of discounted cash flow valuation (DCF). Discounted cash flow valuation looks for present value, which has to be invested in order to obtain specific amount of money at the end of process. This valuation depends both on time value of money and opportunity cost of capital. Net present value (NPV) and internal rate of return (IRR) are the two methods of DCF valuation. The preferred one is NPV whereas it still has some disadvantages which I will focus on afterwards. The main aim is to pick up reasons why IRR is less recommended compared to NPV technique.

Net Present Value

Net Present Value approach is a measure for assessing the profit arising from investment. It is measure of how much could be added to an initial cash outflow by undertaking an investment. It is the difference between project’s market value and its cost. NPV accounts for the time value of money by expressing future cash flows in terms of their value today, by discounting. It recognises that money has a cost (interest), so that one would prefer to have a certain amount of money today rather than in future. If there is an interest rate of 20% when the money is invested, £10 today will be worth £12 a year from now. In other words the present value of £12 in one year is £10. The formula is as following, defined by several books (e.g. Arnold, 2008):

where: 2

NPV - is net present value CF0 - is cash flow at time 0 CF1 - is cash flow at time one CFn - is cash flow at time n k - is the opportunity cost of capital

When the NPV is higher or equal to zero, option could be accepted whereas when the value is less than zero, option should be rejected.

Internal Rate of Return

E.J. McLaney (1994) defines IRR in his book as follows: ‘This approach seeks to identify the rate of return that an investment project yields on the basis of the amount of the original investment remaining outstanding during any period, compounding interest annually.’ In another wording IRR gives you percentage of return you are about to receive by undertaking a project or investment. The formula is defined by several authors (e.g. Arnold, 2008):

a)

or

b)

where: CF0 - is cash flow at time zero CF1 - is cash flow at time one

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CFn – is cash flow at time n in formula a) CF0 is expressed as a positive number, whereas in formula b) is usually negative number

When IRR is higher than opportunity cost of capital, investment is worth it.

NPV vs. IRR

Both of these tools take into account time value of money and opportunity cost of capital linked to the fact that they are methods of discounted cash flow valuation which is based on looking from future to present. The decision rule is same in both cases; the higher, the better. Moreover they relate to each other; the NPV=0 when IRR becomes it´s discount factor. In some cases they agree in their decision. However there are many examples when they are mutually exclusive, when the values are contrary (negative and positive). That means NPV and IRR could rate alternative options differently. Worked example I have prepared an example to show some features and relations of NPV and IRR to each other. An individual wants to decide if investing into a car washer will be profitable. The initial cost is €10 000 and annual net profit is estimated to be €2 535. Discount rate is 5%. In exhibit 1.1 NPV shows a positive value, which means that present value of profit arising from this investment is € 975. IRR is 8,4588 % which is 3,4599% more than discount rate, investment is worthful. In this case both figures of merit come to same conclusion.

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EXHIBIT 1.1 Estimated cash flow for 6 years - project of...