LO3: Week 6• Time Value for Money and DCF• Money is invested in a project to earn profit. For example, If an equipment cost90,000 and would earn a cash profit of 30,000 each year for three years, it wouldnot worth investing. This is because total profit over three years (90,000) wouldonly just cover the cost of the equipment• Capital investment must make profit to justify the cost• The size of the profit or return must have to be large enough to make theinvestment worthwhile• For example, if the equipment cost 90,000 and make a total return of 150,000over three years, the return on investment would be 60,000LO3 Week 6Time Value for Money and DCF Cont.• Money has time value. This means that money can be invested to earninterest or profit• So it is good to have 1 Pound now than in one year time because 1 Poundnow can be invested for the next year to earn profit• Whereas, 1 Pound in one year time cannot earn a profit• Another way to look at time value for money is that 1 Pound in 6 years timeis worthless than 1 Pound now• DCF: Discounted cash flow in capital investment is a tool that takes intoaccount the time value for moneyDiscounted Cash Flow (DCF)• This tool takes care of both timing of cash flows and the total cash flows over aproject life• It is based on future cash flows and not accounting profit• The timing of the cash flows is taken into account by discounting them to apresent value• The effect of discounting is to give a higher value to each 1 Pound of cash flowsthat occur earlier than a lower value to each 1 Pound of cash flows occurringlater in the project life• 1 Pound earned after one year will be worth more than 1 Pound earned aftertwo yearsDiscount Factors and Discount table•A present value for a future cash flow is calculated bymultiplying the future cash flow by a factor•1/(1+r)n•Where 1 is constant•R= cost of capital•N= the number of yearsDiscount Factors and Discount table Cont.• For example, let us say a cost of capital is 10% and the number of years for theproject is 3 years, calculate the DCF• 1/(1+r)n• 1/(1+10)3• 1/(1+0.10)3• 1/(1+1.1)1• 1//1.1• 0.909Discount Factors and Discount table Cont.•1/(1+1.1)2•1//1.1)2•1/(1.1) x (1.1)•1/(1.21)•0.826Discount Factors and Discount table•1/(1+1.1)3•1//1.1)3•1/(1.1) x (1.1) x (1.1)•1/(1.31)•0.756Determination of Present ValueTo calculate a present value for a future cash flow, you have to multiply the future cash flowby the appropriate discount factorAny cash flow that takes place at the start of the project takes place at year 0, so thediscount factor for Year 0 is 1.0 regardless of what the cost of the capital isExamples: The cash flows for a project have been estimated as followsThe cost of capital is 6 %. Calculate the present value?Year Cash Flows0 (30,000)1 7,0002 11,0003 9,0004 8,000Solution Present Value YearCash FlowDCF 6%PV0(30,000)1.00(30,000)17,0000.9436,601211,0000.8909,79039,0000.8407,56048,0000.7926,336 Solution Cont.• Present Value 30,287Quick CheckThe cash flows for a project have been estimated as followsThe cost of capital is 8 %. Calculate the present value?Year Cash Flows0 (50,000)1 10,0002 15,0003 10,0004 15,000Net Present Value (NPV)• The net present value (NPV) tool of the DCF analysis is to calculate the netpresent value for a proposed investment project.• The NPV is the value obtained by discounting all the cash outflows and inflowsfor the project capital at the cost of capital and adding them up• Cash outflows are negative and inflows are positive values• The sum of the present value of al cash flows from the project is the netpresent value• Therefore, the NPV is the present value (PV) of all cash inflows from a projectminus the present value (PV) of all cash out flows.Net Present Value (NPV) Cont.• Positive NPV: This means that the cash inflows from a capitalinvestment will generate a return in excess of the cost of capitalThis is financially attractive• Negative NPV: This means that the cash inflows from a capitalinvestment will generate a return below of the cost of capital Thisis financially unattractive• Zero NPV: This means that the cash inflow from a capitalinvestment will generate a return exactly equal to the cost ofcapital. Thus, the project is just about financially attractive•Illustration of NPV• Chicken Fried Rice Limited is considering a capital investment in new equipment.The estimated cash flows is as follows• Year Cash flows• 0 (240,000)• 1 80,000• 2 120,000• 3 70,000• 4 40,000• 5 20,000• The cost of capital is 9 %. Calculate the NPV to determine whether it is worthwhileSolution YearCash FlowDECF 9%PV0(240,000)1.00(240,000)180,0000.91773,3602120,0000.842101,040370,0000.77254,040440,0000.70828,320520,0000.65013,000 Solution Cont.• Present Value = 269,760• Cost 240,000• NPV 29,760Quick Check• Nickson Limited is considering investing in a new motor car for the delivery of its projectwhich will make savings over the current out-sourced services• The cost of the motor car is 75,000 and it will have a six years life• The savings it will make over the period are• Year Cash Flows• 1 20,000• 2 22,000• 3 30,000• 4 10,000• 5 15,000• 6 10,000• The cost of capital is 12 %. Calculate the net present value?Internal Rate of Return (IRR)• The internal rate of return (IRR) tool of the DCF analysis is to calculate the exact ofDCF rate of return that the project is expected to achieve• This is the cost of capital at which the net present value (NPV) is zero• If the expected rate of return (IRR) and also has a DCF yield is higher than therate of return, the project is financially worthwhile• The IRR calculation can be done easily by looking at the positive and negativeNPVs to determine the rate of return far above the cost of capital• Formula• IRR LR + = NPV (HR-LR)(Combined NPVs)IRR Formula•Where IRR = Internal rate of return•NPV+ = Positive NPV•NPV- = Negative NPV•HR = Higher Rate•LR = Lower RateIllustration• Chicken Fried Rice Limited is considering a capital investment in new equipment. Theestimated cash flows is as follows• Year Cash flows• 0 (240,000)• 1 80,000• 2 120,000• 3 70,000• 4 40,000• 5 20,000• The cost of capital is 9 %. Calculate the IRR to determine whether it is worthwhileSolution YearCash FlowDCF 9%PV0(240,000)1.00(240,000)180,0000.91773,3602120,0000.842101,040370,0000.77254,040440,0000.70828,320520,0000.65013,000 Solution Cont.• Present Value = 269,760• Cost 240,000• NPV 29,760Solution YearCash flowDCF 18%PV0(240,000)1.00(240,000)180,0000.84767,7602120,0000.71886,160370,0000.60942,630440,0000.51620,640520,0000.4378,740 Solution Cont.• Present Value = 225,930• Cost 240,000• NPV 14,070Solution (IRR)• IRR = LR + NPV (HR-LR)• (Combined NPVs)• IRR = 9 + 29,760 (18-9)• 29,760+14,070• IRR = 9 + 29,760 (9)• 43,830• IRR = 9+ 0.678 X 9• IRR = 9 + 6.102• IRR = 15.1 %Quick CheckNickson Limited is considering investing in a new motor car for the delivery of itsproject which will make savings over the current out-sourced services• The cost of the motor car is 75,000 and it will have a six years life• The savings it will make over the period are• Year Cash Flows• 1 20,000• 2 22,000• 3 30,000• 4 10,000• 5 15,000• 6 10,000• The cost of capital is 12 %. Calculate the internal rate of return?Financial Ratio Analysis• Ratio analysis refers to the analysis of various pieces of financial information inthe financial statements of a business.• They are mainly used by external analysts to determine various aspects of abusiness, such as its profitability, liquidity, and solvency.• Analysts rely on current and past financial statements to obtain data to evaluatethe financial performance of a company.• They use the data to determine if a company’s financial health is on an upward ordownward trend and to draw comparisons to other competing firms.Uses of Financial RatiosComparisons• To compare a company’s financial performance to similar firms in the industry tounderstand the company’s position in the market.• Obtaining financial ratios, such as Price/Earnings, from known competitors andcomparing it to the company’s ratios can help management identify market gapsand examine its competitive advantages, strengths, and weaknesses• The management can then use the information to formulate decisions that aimto improve the company’s position in the market.Uses of Financial Ratios Cont.Trend Line• Companies can also use ratios to see if there is a trend in financialperformance.• Established companies collect data from the financial statements over alarge number of reporting periods.• The trend obtained can be used to predict the direction of future financialperformance, and also identify any expected financial turbulence that wouldnot be possible to predict using ratios for a single reporting period.Uses of Financial Ratios Cont.Operational Efficiency• The management of a company can also use financial ratio analysis todetermine the degree of efficiency in the management of assets andliabilities.• Inefficient use of assets such as motor vehicles, land, and building results inunnecessary expenses that ought to be eliminated.• Financial ratios can also help to determine if the financial resources areover- or under-utilized.Types of Financial RatiosLiquidity Ratios• Also known as Solvency Ratios, focuses on a company’s current assets andliabilities to assess if it can pay the short-term debts.• The three common liquidity ratios used are current ratio, quick ratio, andburn rate.Profitability Ratio• How it uses its assets and how effectively it generates the profit from theassets and equities.• This also then gives the analyst information on the effectiveness of the useof the company’s operations• .Working Capital Ratio• This analyses if the company can pay off the current debts or liabilities using thecurrent assets.• This ratio is crucial for the creditors to establish the liquidity of a company, andhow quickly a company converts its assets to bring in cash for resolving the debts RatiosFormulaInventory RatioNet Sales / InventoryDebtors Turnover RatioTotal Sales / Account ReceivablesCreditors Turnover RatioNet Credit Purchases / Average AccountsPayableAccount receivable periodDebtors/sales x 365Account payable periodCreditors / purchases x 365 Capital Structure Ratio• These ratios, i.e., the Capital Structure Ratios, analyze how structurally a firmuses the capital or funds.Interest cover ratio• This shows how fast a business can pay their interest expenses on unsettleddebt• Earnings before interest and taxes (EBIT)/company’s interest expensesIllustration LiabilitiesPAssetsPEquity share CapitalPreference sharesReserves6% MortgageDebenturesCurrent liabilitiesCreditorsBill payableAccrued expensesTax Provision20,0004,00016,00028,0002,4004,0004005,200Fixed assetsCurrent assetCashInvestmentDebtorsstock52,0002,0006,0008,00012,00080,00080,000 Other information• Net sales 120,000• Cost of goods sold 103,200• Net income before tax 8,000• Net income after tax 4,000SolutionCurrent ratio = 28,000- 12,000• CR = 16,000Quick Ratio 28,000-12,000/12,000• Quick ratio = 16,000/12,000 = 133Debt equity ratio = 80,000 – 24,000 = 56,000Solution Cont.• Debtors turnover ratio 120,000-8,000 = 112,000• Creditors turnover ratio 103,200 – 400 = 102,800• Net Profit ratio = 8,000/120,000 x 1006.6 or 7 %

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