Discounted and non-discounted cash flow techniques - Essay Example

?Introduction This report aims at appraising four different projects on the basis of both discounted and non-discounted cash flow techniques. After the relevant computations, one project will be advised to be accepted. This report also highlights the projects appraisal techniques in detail such that every technique will be discussed and its strengths and weaknesses will be elaborated. One by one every project will be considered for appraisal and its relevant computations will be provided in the appendix. The decision as to which project is to be accepted lies basically on two broader grounds namely as financial and non-financial. Here the financial grounds are discussed such that financial grounds itself can be bifurcated on two basis which are discounted cash flow techniques and non-discounted cash flow techniques. The discounted cash flow techniques have both the absolute and relative techniques. The most popular absolute technique is Net Present Value (NPV) technique which has also been used in this current analysis. The relative discounted cash flow techniques may have various forms in which the famous ones are Internal Rate of Return (IRR) and Profitability Index (PI). On the other hand, the non-discounted cash flow techniques consist of Payback Period, Urgency and Accounting Rate of Return (ARR). Discounted Cash Flow Techniques In this particular analysis, NPV, IRR and PI are used as discounted cash flow techniques to appraise the project whereas only Payback is used as non-discounted cash flow technique as other techniques cannot be used because the non-availability of the relevant data. The following discussion contains detailed explanation of discounted cash flow techniques. Net Present Value Net Present Value technique is the most famous project appraisal technique such that it explains the benefits of the project in an absolute financial sense. This technique provides an absolute figure as how much the project would earn given in its project life. This technique works on the basis of discounting such that cash out flows and flows are discounted through an appropriate discount rate which is generally the weighted average cost of capital. In the way, the present value of all cash outflows and inflows are computed and then all the present values are summed up to obtain the Net Present Value of the project. Strengths The strength of this technique is that it provides an absolute amount which reflects the overall benefits that the project can provide now. This technique is also quite simple to calculate and quite easy to understand. Weaknesses The weaknesses include that the NPV of a particular project can exactly be equal to another project but both the projects may have significant differences in the magnitude of the cash flows. Another weakness of the technique is that it is based on the future expectations such that cash flows are projected with judgment. In case if the economic and financial situation changes, then the actual results may vary significantly from the estimates NPV. Comprehensive financial knowledge is also required to compute the NPV especially in those projects where tax implications have the key impact upon the generation of cash flows. Internal Rate of Return This discounted cash flow technique is also quite popular among the financial analyst such that it works on the basis of NPV. Internal Rate of Return is that rate at which the Net Present Value of a project becomes zero. This means that if the IRR is used as a discount rate instead of WACC which can produce a nil NPV. Hence if IRR exceeds than WACC, then the project can produce positive NPV. However, if IRR remains lower than WACC then NPV would also remain in a negative zone. Strengths The biggest strength of IRR is that it is a relative measure and a comparable one. It is also easier to understand the logic that works behind it. The interpretation of IRR is quite easy and this technique is also quite consistent with the objective of maximizing the wealth of shareholders. Weaknesses There are many drawbacks of this technique as well. As NPV is the major driving force behind this technique, thus the negative elements of NPV are also included in this technique. The other drawbacks that are also quite prevalent include the difficulty of calculating IRR such that interpolation and trial and error methods are used to calculate IRR which are quite time consuming. Another major pitfall of this technique is that it works on the basis of conventional cash flows such that initial out flow exists in the first year then followed by series of inflows till the end of the project. However, in case if unorthodox series of cash flows occurs in a particular project, then this technique becomes useless. Profitability Index This technique also works on the basis of present values of the discounted cash flows but it is not quite popular among the analysts. In fact, this technique is more of a molded form of the NPV. In this technique the ratio of present value of all cash inflows to Initial Investment or outlay is calculated. If the ratio exceeds 1 than the project can be accepted otherwise it should not be. An important thing to note regarding this technique is that if the ratio exceeds 1, it means that the NPV of the project would be positive and if it remains less than 1, then the NPV will remain negative. Thus it is just a twisted form of NPV. Strengths The promising strength of this technique is that it has a backing of NPV behind it. The ratio is simple to understand and the decision can be taken easily on the basis of the calculated ratio. Another important strength of this technique is that it provides a relative value which can be compared for decision making. In case when a firm lacks in determining the financial resources and it cannot accept every project that has the positive NPV as well as solid IRR, the profitability index is used as a tool for capital rationing and allows the firm to pick out the best project among number of different projects. Weaknesses This technique has the similar drawbacks that NPV possess such that the future estimation of project cash flows is subject to judgment and the actual cash flows may differ in real from the estimates ones. Non-Discounted Cash Flow Techniques These are the techniques in which the original values with the differing time periods are used. Mainly Payback, Urgency and Accounting Rate of Returns are used to appraise the projects but for this particular analysis, only Payback would be used as a decision making criteria for different projects. Payback This technique traces as to when the initial investment of the project would be recovered. The estimated time period to recover the initial investment is computed by this technique. This technique works on the cumulative cash flows such that the year in which the cumulative cash flow become positive, the time spent till that period would be considered as the payback period. That is, the time in which all the cash outflows are recovered by the project. Strengths The biggest strength of this technique is that it estimates the time required for the recovery of initial investment. The lesser the payback, the higher will be the chances to accept the project. This technique is also easier to calculate as well as convenient in understanding. Weaknesses The weakness of this technique is that in case if there comes any deviation in the series of cash flows, then the payback period might vary from the estimated period. The estimation of cash flows is also subject to the judgment of the analysts which can be proved as wrong. The issue of time value of money is also associated with this technique such that the cumulative cash flows are taken into account for different time periods. The solution of this weakness is to use the discounted payback period which can eliminate the effect of varying time periods used in the technique. Project Appraisal The following discussion will highlight each project in isolation as well as in comparison with other projects in order to appraise one project out of the four. Each project is analyzed in the light of both discounted and non-discounted cash flow techniques and the results of each technique in respect of every project are detailed as under: Machine A For machine A, it can be observed that this project results in NPV of ?1,500,000 with the IRR of 17.13% which is 6% more than the benchmark cost of capital which is 11%. The profitability index of the project is also good enough and stands at 1.19. However, the Payback period of the project is 3.5 years in which the initial investment of the project is likely to be recovered. Therefore, on the basis of discounted cash flow techniques, each indicator has shown a positive sign for the acceptance of this particular project. Machine B The NPV calculated for machine B is ?1,441,000 with the IRR of 17.28%. The Profitability Index of the project remains at 1.14. The Payback period for machine B was estimated to be 2.38 years which is the minimum time in all projects in question. Overall, this project has shown good signs in respect of both discounted and non-discounted cash flow techniques of appraising the projects. Machine C This machine earns a negative NPV of ?1,537,000 which can be considered as a loss to the project. The IRR of the project is also less than the benchmark cost of capital of 11% and remains at 5.58%. Profitability Index of this project is also less than 1 and remains at 0.87. The payback period for the project is estimated to be exactly 4 years. Note that if discounted Payback technique had been used, the payback period would not have been calculated because the present values of discounted cash flows would not have recovered the initial investment. Machine D For this machine, the amount of NPV is calculated as ?1,114,000. The IRR of the project also remained considerably significant and stood at 13.20%. Profitability index for this project has also been consistent and remained at 1.08. The overall time period required to recover the initial investment is 4.8 years. The results of this project appraisal are quite satisfactory and this project can also be accepted if the company had the choice of investing only in this project. However, there are three other projects as well, therefore the company should evaluate the comparative analysis of all the projects and then decide as to which project reveals the best outcomes for the company. Recommendation If a comparative analysis of all the four projects is undertaken, it can be noted that Machine C results in negative and adverse signs and Machine D is positive in different aspects but still way far behind from those of Machine A and Machine B. The overall financial indicators based on discounted cash flows are similar for both Machine A and Machine C such that both machines generate NPVs of around ?1.5 million, IRR of around 17% and Profitability Index of around 1.15. However, the payback period for Machine B is 2.38 years and for Machine A is 3.5 years. Therefore, it is recommended that project in respect of Machine B should be adopted as it will yield in the maximum benefits to the company. As far as all the investment appraisal techniques that have been employed in this analysis, it can be observed that the discounted cash flow techniques have portrayed far better and decisive results. If discounted payback technique had been applied in the appraisal of these four projects, there would have been a likelihood of obtaining slight different results as compared to the existing results. Appendix Machine A     Years 0 1 2 3 4 5 6 NCF (80) 15 25 25 30 30 10 WACC (11%) 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 Discounted Cash flows (80) 13.51 20.29 18.28 19.76 17.80 5.35 NPV 15.00   IRR 17.13%   Profitability Index 1.19       Years 0 1 2 3 4 5 6 NCF (80) 15 25 25 30 30 10 Cumulative Cash Flows (80) (65) (40) (15) 15 45 55 Payback Period 3.50 Years                   Machine B     Years 0 1 2 3 4 5 6 NCF (100) 35 40 40 15 10 10 WACC (11%) 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 Discounted Cash flows (100) 31.53 32.46 29.25 9.88 5.93 5.35 NPV 14.41   IRR 17.28%   Profitability Index 1.14       Years 0 1 2 3 4 5 6 NCF (100) 35 40 40 15 10 10 Cumulative Cash Flows (100) (65) (25) 15 30 40 50 Payback Period 2.38 years                   Machine C     Years 0 1 2 3 4 5 6 NCF (120) 25 35 40 20 10 10 WACC (11%) 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 Discounted Cash flows (120) 22.52 28.41 29.25 13.17 5.93 5.35 NPV (15.37)   IRR 5.58%   Profitability Index 0.87       Years 0 1 2 3 4 5 6 NCF (120) 25 35 40 20 10 10 Cumulative Cash Flows (120) (95) (60) (20) 0 10 20 Payback Period 4.00 years                   Machine D     Years 0 1 2 3 4 5 6 NCF (140) 10 20 50 50 50 50 WACC (11%) 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 Discounted Cash flows (140) 9.01 16.23 36.56 32.94 29.67 26.73 NPV 11.14   IRR 13.20%   Profitability Index 1.08       Years 0 1 2 3 4 5 6 NCF (140) 10 20 50 50 50 50 Cumulative Cash Flows (140) (130) (110) (60) (10) 40 90 Payback Period 4.80 years                   References Baker, H. 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