Module 12: Capital Budgeting
Skill Building
HAP395: Healthcare Finance
Time Value of Money Concepts – Part 2
Discounted Cash Flow Analysis in 8 Steps
Objectives:
Develop an understanding of the Discounted Cash Flow (DCF) techniques in making capital investment and other financial decisions.
Practicing the DCF technique using a prepared Excel spreadsheet.
Practicing changing assumptions in an analysis in preparing “what it” analyses.
Gain experience using the Quantitative Literacy Checklist in understanding these concepts.
The Eight Step Process for Preparing a DCF Analysis
Preparing a discounted cash flow analysis takes eight steps. As shown here, both the Net Present Value and Internal Rate of Return are computed, although some organizations compute only one or the other.
Step 1: Choose the time period involved in the investment alternative.
When choosing the time period you will typically consider two variables. The first variable is the length of time of the investment. For a piece of equipment, it is usually the life of the equipment. After a period of years, the equipment may be sold at which time the project is complete and the final year will include the cash flow from the sale.
The second variable is to determine the number of periods in which to divide the time. It is most common to use the number of years, especially in analyzing projects that will last many years. One could use months or quarters in analyzing investments, and this might be appropriate with a financial security such as a bond. Using months or quarters for equipment or project analysis, however, becomes unwieldy. It is common to use timing of annual cash flows with the additional assumption that the flow will occur at the end of the year. Flows in reality will occur throughout the year; however the year end convention is common and yields reasonably good results.
Step 2: Determine the cash flows involved.
Cash flows come in two general types: Inflows, or cash being received; and outflows, or cash being expended or invested. Note that a project that is expected to save expenses treats those savings as a cash inflow.
Flows over time might be either as a single sum or as a series.
Thus, there are four typical patterns of cash flow for any investment.
a) Out In
b) Out Out Out Out . . . In
c) Out In In In . . .
d) Out Out Out Out . . . In In In . . .
The first out flow, if done today, in the present, is made in period “0″. Subsequent flows will be noted in the subsequent periods.
Step 3: Determine the Net Cash Flow
This is determined by summing all of the net inflows and subtracting the net outflows from these. To keep these amounts organized it is common to treat all inflows as a positive number, and all outflows as a negative number.
The end result is a series of net cash flow by period, starting with period 0 and ending with the final period of the project; not one number, but a series of numbers; one for each period.
Step 4: Select a discount rate in which to discount the future cash flows to the present.
The discount rate is the “hurdle rate”, that is, the rate at which the organization will place on this project so that if it “clears” this rate (as a runner in track might clear a hurdle) the project will be deemed financially attractive. If the project does not clear the parameters established by the hurdle rate, the net present value of the project will be a negative number.
This will mean that the present value of all future inflows does not equal at least the present value of the initial outflow, deeming the project financially unattractive.
While a “hurdle rate” might vary by project depending on the amount of risk involved, a common practice is to use an organization’s “cost of capital” as the discount rate. This cost of capital rate is the hypothetical rate that must be earned on the investment such that the overall value of the firm will not be changed. In for-profit companies it is a blend of the amount of money it costs, net of taxes, to borrow cash (interest expense), blended with the amount of money it costs associated with common stock.
(In this case it is a function of the dividends and stock appreciation expected by the owners). In not-for-profits, because there is no stock, the cost of capital is at least the cost of the organization’s debt, or the interest rate on the debt it has.
Step 4c is not to worry about the rate selected in step 4a. There are enough estimates involved in discounted cash flow analysis that the selection of the rate is unlikely to make a significant impact on the deciding the attractiveness of the investment as long as a reasonable rate is used. Reasonable means no lower than the cost of the next dollar of debt which would be paid.
Step 5: using the discount rate, compute the net present value of the investment. This can be done in one of several ways.
Using a financial calculator, the net cash flows can be entered by year.
This method is long and tedious and is not particularly desirable. Still it can be done, and somewhere in the instruction manual of the calculator is a long explanation on how to accomplish this. Try it if you want to, however, this is not recommended.
Using a financial present value table, the net present value of $1 can be determined for each year. (You can also determine this using the appropriate mathematical formula found in the text). Simply multiply this factor by the net cash flow to get the discounted cash flow or that year.
Sum all of the years, including year 0 and the total will be the Net Present Value.
Using a financial spreadsheet, both methods one and two can easily be done. This is likely the most efficient way to do this task.
a) A spreadsheet such as Excel has NPV formulas which will automatically compute the present value of a stream of cash flows at a given discount rate.
b) The spreadsheet can also compute the appropriate discount factors by year, multiply them by each year’s net cash flow, and sum them to arrive at the net present value. If the spreadsheet is done appropriately, both methods can be done with the longer manual calculations being done as a check.
Step 6: Determine if the sum of each year’s discounted present value.
If the Net Present Value is greater or less than 0, then the project adds value to the organization. If less than 0, the project reduces the value of the organization.
Step 7: Using the cash flows identified, determine what discount rate would be appropriate in order to make the net present value equal to zero.
This value by definition is the Internal Rate of Return (IRR) of the project or investment. “Internal” because it typically will be a project that an organization might undertake by purchasing equipment and doing something inside of the organization to produce a product for sale, or to save costs; “Rate of Return” because it is an expression of an interest rate which can equate the flows of the investment with that of an external investment such a bond or bank account.
a) If the internal rate of return of the project is greater than the hurdle rate, then you have a “winner”. If less, the project is a “loser”. The spread between the IRR and the hurdle rate is the “Computational Risk” associated with the selection of the discount rate. The larger the spread, the less the discount rate selected has to do with the generation of a positive NPV.
A great advantage of using spreadsheets, in addition to their accuracy, speed, and ease of use once you know the basics, is the ability to perform “what if” analysis. If one changes assumptions, what will be the new results? This type of exercise is termed “sensitivity analysis” and is valuable in gaining insight as to the level of impact of changes made.
Step 8: Reflect on your answers, assumptions, and process.
Using concepts introduced in the Quantitative Literacy Rubric/Checklist used in this course, think about the various results you have calculated. Do they appear reasonable? What assumptions went into this analysis that may give you some concern? What conclusions can you make from this analysis? How will you communicate these results to others?
Other analytical values determined by DCF analysis
The DCF analysis yields two are values that are sometimes uses in analyzing investments.
The first is the “Profitability Index”. This is an index used to compare one investment alternative with others. Values above one are desirable, with the higher the value, the financially better the alternative.
a) The computation for the Profitability Index is to take the NPV for all future cash flows and divide that by the value of the initial investment.
b) The second is the “Payback Period”. This value measures the time it takes to recoup the investment inflows to a level to equal the initial investment. This time is normally measured in years, with shorter payback period being better than longer ones. For this analysis, traditional payback calculations use undiscounted cash flows, which is a drawback as it does not take into account the time value of money. An alternative is to use discounted cash flows to determine a discounted payback period.
III. Discounted cash flow analysis is often used in two types of analysis.
The analysis of a capital investment. An investment might be a financial investment, such as a bond, or it might be a piece of equipment, project, or new service line which includes a combination of equipment and operating expenses.
The analysis of financing options, particularly when confronted with the decision of purchasing a piece of equipment or leasing it.
In both cases, the fundamental seven-step process can be used.
An example of using the DCF Eight Step Process
Using the accompanying spreadsheet as a template, compute the net present value (NPV), the internal rate of return (IRR), the Profitability Index, and the Payback Period using discounted cash flows, for a project with these assumptions:
The initial price of a piece of equipment we’ll call “Project A” will be for $100,000.
Gross revenues associated with the program using this equipment will be $60,000 each year for 5 years.
Net revenues associated with a program using this equipment will be $40,000 each year for 5 years, thus the deductions from revenue year will be $20,000.
Expenses will be $10,000 each year for 5 years.
The equipment will be sold for $10,000 after the end of the five years.
The discount rate to be used will be 10%.
Change these variables and note the new results:
Changing the purchase price from $100,000 to $110,000 yields these values.
Keeping the $100,000 purchase price, and decreasing the discount rate from 10% to 8% yields these values.
The answers are noted below as well as on separate tabs of the accompanying Excel Spreadsheet.
Answers to Project A Base Problem:
Net Present Value (NPV) = $19,933
Internal Rate of Return (IRR) = 17.23%
Profitability Index = 1.20
Payback Period using discounted cash flows = 4.20 years
Answers to change 1 — Increasing purchase price by $10,000:
Net Present Value (NPV) = $9,933
Internal Rate of Return (IRR) = 13.34%
Profitability Index = 1.09
Payback Period using discounted cash flows = 4.60 years
Observation: Increasing the purchase price lowers the NPV; lowers the IRR; decreases the Profitability Index; and lengthens the Payback Period.
Answers to change 2 — keeping original purchase price and decreasing
discount rate from 10% to 8%:
Net Present Value (NPV) = $26,587
Internal Rate of Return (IRR) = 17.23%
Profitability Index = 1.27
Payback Period using discounted cash flows = 4.02 years
Assumptions:
For your analysis assume that the Center uses a 7% discount rate for projects of this risk level, and that they will initially use a five-year time horizon. This is a tax-exempt not-for-profit organization so there will not be any income tax effects to consider in the calculations.
The business after buying the equipment is expected to generate gross revenues of $140,000 each year in the first two years and is expected to be $190,000 each year in the next two years, followed by $240,000 in the fifth year. The services will be paid for by third parties and there is a demand for this new service. Since the third-party payers will pay less than the full charge, assume that deductions from revenue to average 20% of gross revenues in each of the five years. The equipment cost is $425,000 and will cost $45,000 to install. After five years the equipment will be retired, and it is expected that it could be sold for $60,000.
The costs for the service include part-time staffing costs of $13,000 and supply costs of $10,000 in each of the first two years. For the following two years, salaries are expected to be $15,000 and supplies are estimated to be $13,000; and in the last year five, salaries are expected to be $22,000 and supplies are expected to be $18,000. The equipment is under warranty in the first year so there is no extra fee paid. A maintenance contract costing $6,500 per year will be paid in years 2 through 5.
Use the template spreadsheet and 8-step process to enter the above assumptions in the appropriate cells.
Compute the Net Present Value of Future Cash Flows, and the Internal Rate of Return. Highlight in yellow those two answers on your spreadsheet. Note those answers in the table below so that they are in both places.
Note at the bottom of the schedule whether this is an attractive project from a purely financial point of view based upon the numbers that you calculated on the spreadsheet. Why did you make that decision? Note your answers in the table below so that they are in both places.
Optional Additional Point Opportunity:
Copy your spreadsheet tab with your answer and label the new tab “Six Years”. Add a Year 6 column and assume that year six cash inflows and outflows will be the same as year 5, with the exception that the equipment will be sold for $40,000 at the end of year 6 instead of $60,000 at the end of year 5. Adjust any formulas in the cells as appropriate caused by the addition of a year 6. Compute the new Net Present value and Internal Rate of Return for this six-year project. Highlight those answers in yellow on your spreadsheet. Note those answers in the table below so that they are in both places
