Project Appraisal Using Discounted Cash Flow
In the interest of stronger economies and economic growth, decisions on resource allocation in organizations require a systematic, analytical, and thorough approach, as well as sound judgment. Investment (project) appraisals and capital budgeting, which involve assessing the financial feasibility of a project, should use Discounted Cash Flow (DCF) analysis as a supporting technique to (a) compare costs and benefits in different time periods, and (b) calculate net present value (NPV). NPV utilizes DCF to frame decisions, to focus on those that create the most value.
This International Good Practice Guidance (IGPG) covers DCF analysis, and supports professional accountants in business who evaluate investments to support decisionmaking. In advocating fundamental principles and providing guidance on how to use DCF analysis, this IGPG establishes a benchmark that can help professional accountants to deal with the complexities of practice. Investments include major capital spending and strategic investments such as product development, and acquisitions and divestitures that shape the future of an organization (see paragraph 2. 1).
Companies with good records in value creation tend to have better access to capital and a more motivated and productive workforce. This IGPG supports and encourages professional accountants in business to promote (a) disciplined financial management in organizations, and
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Delivering public and not-for-profit services requires a focus on (a) ensuring that public funds are spent in the most efficient and effective way, and (b) activities that provide the desired benefits to society.
This IGPG encourages professional accountants in business to promote the use of DCF analysis and NPV to evaluate investments. Adoption and prioritization of these techniques will vary depending on jurisdiction, size of organization and organization type. For example, organizations with explicit value creating strategies may emphasize DCF and NPV, and downplay the role of other criteria such as payback and EPS growth. Conversely, a restructuring organization experiencing poor performance may emphasize short-term financial performance and criteria such as EPS growth.
However, research shows that a significant number of organizations do not prioritize DCF and internal rate of return (IRR) when perhaps they should, especially in assessing strategic investment decisions and taking a long-term view. In smaller organizations, use of DCF and IRR is particularly variable, as many rely on relatively simple approaches such as payback criteria and informal rules of thumb.
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The Role of the Professional Accountant in Business
The importance of the role of professional accountants in business in supportingc ommunication of information within organizations and to its outside stakeholders is highlighted in the IFAC Code of Ethics for Professional Accountants. Paragraph 300. 2 states that investors, creditors, employers, and other sectors of the business community, as well as governments and the public at large, may all rely on the work of professional accountants in business. Professional accountants in business may be solely or jointly responsible for preparing and reporting on financial and other information on which both their employing organizations and third parties may rely. To this end, professional
accountants in business should (a) apply high standards of DCF and NPV analysis, (b) establish safeguards to compensate for risks to the integrity of information flows, and (c) provide objectivity where conflicts of interest could influence a decision. In this context, professional accountants in business both challenge and contribute to decision-making.
DCF analysis and estimating the NPV of cash flows incorporate fundamental principles of finance that support disciplined financial management in organizations. Professional accountants in business have a role in promoting and explaining the importance of these
principles in their organizations, particularly where the connections between the application of financial principles and related financial theory are not easily understood or accepted. A key challenge in using DCF arises from the confusion that often occurs in understanding its theoretical basis and practical application.
Professional accountants in business can promote the use of both DCF and NPV in investment appraisal and advise on the appropriateness of other techniques for specific contexts. They can also directly (a) conduct DCF analysis, and (b) ensure the quality of
information flows, to support analysis and appraisal of the investment.
Professional accountants in business who work in a finance and accounting function of an organization may participate in interdisciplinary teams, whether at a marketing, research and development, or other functional interface, that assess the effectiveness of investments. For example, marketing expenditures with longer-term effects, such as product launch advertising and promotions, could be evaluated using DCF to analyze expenditures and earnings. Some organizations with significant brand investments have used professional
accountants in business to develop DCF-based and other tools to provide insights into the effectiveness of these investments. A typical role in this context is helping to (a) frame the decision(s) and the purpose of the analysis, and (b) select the most appropriate approach and tools, given the context of the decision and the end user’s information requirements.
In investment appraisal and capital budgeting, professional accountants in business could participate in (a) recognizing the investment opportunity, (b) determining the alternatives, (c) ensuring that information is used in a way that leads to the selection of the best
alternative, and (d) subsequent checking to establish whether anticipated benefits have been realized. Many organizations require consideration of at least three alternative investment options in making decisions.
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In addition to using DCF analysis to help an organization improve decision-making, professional accountants in business could encourage a wider assessment of the strategic impact and economic rationale of a potential investment. Organizations should place investment appraisal in a wider strategic context. For example, determining whether
acquisition or internal growth is most effective in reaching an organization’s strategic objectives requires an understanding of the business environment and an organization’s specific situation. A wider strategic analysis might include an assessment of (a) market economics, (b) economic profitability across markets, products, and customers, (c) determinants of sustainable profitable growth and competitive position, and (d) alternative options. In this context, where appropriate, professional accountants in business could encourage consideration of a range of stakeholders in assessing potential investments.
That range could include employees, managers, communities, customers, suppliers, the industry, and the general public.
Professional accountants in business could advise on the alignment of investment appraisal with assessments of subsequent managerial performance. For example, management incentives based on accounting profit could encourage actions that do not support longterm value generation to shareholders. For example, a potentially good (based on NPV criteria) project, supported by a wider assessment of its strategic importance, could result in poor accounting returns in its early years. 2
Key Principles That are Widely Accepted Features of Good Practice Scope of this IGPG 6
Investment (project) appraisal refers to evaluations of decisions made by organizations on allocating resources to investments of a significant size. Typical capital spending and investment decisions include:
• Make or buy decisions, and outsourcing certain organizational functions
• Acquisition and disposal of subsidiary organizations
• Entry into new markets
• The purchase (or sale) of plant and equipment
• Developing new products or services (or discontinuing them), or decisions on related research and development programs
• The acquisition (or disposal) of new premises or property by purchase, lease, or rental
• Marketing programs to enhance brand recognition and to promote products or services
• Restructuring of supply chain
• Replacing existing assets.
Definitions of terms used in this IGPG are at appendix B. The purpose of this IGPG is to support decisions in organizations for managerial purposes. Where DCF and NPV is used PROJECT APPRAISAL USING DISCOUNTED CASH FLOW 7 in connection with financial reporting, professional accountants in business should refer to International Financial Reporting Standards or local GAAP requirements.
A commonly recognized feature of Islamic Finance is the prohibition of interest. While this may affect the use of corporate finance tools and the approach to investment project appraisals, it may not necessarily preclude its use under Sharia Law provided conditions of Sharia are met. For example, the estimation of the timings of future cash flow and estimating the value of a proposed project can be used as a reference or benchmark to support decisions undertaken in Islamic finance.
The Key Principles in Project Appraisal Using DCF
The key principles underlying widely accepted good practice are:
A. When appraising multi-period investments, where expected benefits and costs and related cash inflows and outflows arise over time, the time value of money should be taken into account.
B. The time value of money should be represented by the opportunity cost of capital.
C. The discount rate used to calculate the NPV in the DCF analysis should properly reflect the systematic risk of cash flows attributable to the project being appraised, and not the systematic risk of the organization undertaking the project.
D. A good decision relies on an understanding of the business and an appropriate DCF methodology.
DCF analysis should be considered and interpreted in relation to an organization’s strategy, and its economic and competitive position.
E. Cash flows should be estimated incrementally, so that a DCF analysis should only consider expected cash flows that could change if the proposed investment is implemented. The value of an investment depends on all the additional and relevant cash inflows and outflows that follow from accepting an investment.
F. At any decision-making point, past events and expenditures should be considered irreversible outflows (and not incremental costs) that should be ignored, even if they
had been included in an earlier cash flow analysis.
G. All assumptions used in undertaking DCF analysis, and in evaluating proposed investment projects, should be supported by reasoned judgment, particularly where factors are difficult to predict and estimate. Using techniques such as sensitivity analysis to identify key variables and risks helps to reflect worst, most likely, and best case scenarios, and therefore can support a reasoned judgment.
H. A post-completion review or audit of an investment decision should include an assessment of the decision-making process, and the results, benefits, and outcomes of the decision.
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Application Guidance on Implementing the Principles PRINCIPLE A When appraising multi-period investments, where expected benefits and costs and related cash inflows and outflows arise over time, the time value of money should be taken into account.
A. 1 DCF analysis considers the time value of money, based on the premise that (a) people prefer to receive goods and services now rather than later, and (b) investors prefer to receive money today, rather than the same amount in the future, i. e. , one dollar (or other currency) today is worth more than one dollar tomorrow.
An investor demands a rate of return even for a risk-less investment, as a reward for delayed repayment. Even the riskfree rate of interest is normally positive, because people attach a higher value to money available now rather than in the future.
A. 2 DCF analysis is appropriate for multi-period investments, i. e. , where the expected benefit and costs arise over more than one period. For such investments, DCF supports decisionmaking better than evaluating an investment using payback period or accounting (book) rate of return. DCF recognizes that an investment has cash flows throughout its expected
life, and that cash flows in the early periods of an investment are more significant than later cash flows. Many organizations use several methods for evaluating capital investments, an acceptable practice so long as they only supplement a DCF approach.
A. 3 The major limitation of using payback period as an investment criterion is that it may cause an organization to emphasize short payback periods too much, thereby ignoring the need to invest in long-term projects that could enhance its competitive position. The payback method (unless cash flows are discounted using the opportunity cost of capital)
ignores both the time value of money and cash flows after the payback period. If the payback periods for two projects are the same, the payback period technique considers them equal as investments, even if one project generates most of its net cash inflows in its early years, while the other project generates most of its net cash inflows in the later years.
A. 4 The accounting rate of return criterion also ignores the time value of money. Furthermore, this technique uses accounting numbers that depend on the organization’s choice of accounting procedures. This method uses net income rather than cash flows.
Although net income is a useful measure of profitability, the net cash flow is a better measure of an investment’s performance.
A. 5 Both the NPV and IRR methods discount cash flow, although NPV is theoretically preferable. IRR indicates a potential project’s annual average return on investment in percentage terms. For this reason, it can be useful in (a) communicating an analysis of investment choices to entrepreneurs and employees without financial expertise, and (b) facilitating decisions where the discount rate is uncertain. However, it can provide misleading results in certain contexts.
Calculating the IRR requires identifying the PROJECT APPRAISAL USING DISCOUNTED CASH FLOW 9 discount rate that results in a zero NPV of cash flows. Comparing the IRR with the target rate of return on an investment can be useful in deciding whether to proceed, but it does not reflect the increase in a company’s monetary value flowing from accepting an investment. Furthermore, the NPV approach can incorporate different discount rates for different periods, and cash flow streams of different systematic risks. This allows a proper reflection of changing macroeconomic conditions (inflation and interest rates) and the systematic risk of all projected cash flows. In certain circumstances, such as in multiperiod projects where net negative cash flows are followed by net positive cash flows, and then again by net negative cash flows, there may be more than one IRR for which NPV will be equal to zero. Therefore, using the criterion of NPV>0 as a decision-making tool is better than using the criterion of IRR>cost of capital.
A. 6 For a listed company, using NPV as an aid to making decisions is typically consistent with the creation or maximization of shareholder value (or the market price of shares).
Maximizing shareholder value implies that projects should be undertaken when the present value of the expected cash inflows exceeds the present value of the expected cash outflows. Any investment that demonstrates a positive expected NPV could contribute to shareholder value, because the risk- and time-adjusted expected cash inflows outweigh the expected cash outflows.
A. 7 As with all decisions in an organization, investment appraisal decisions and DCF analysis rely on good quality information. The characteristics of good information include: accuracy, relevance, reliability, consistency, completeness, and timeliness.
All of these can be important in DCF analysis, but usually not all can be included in decision-making. Therefore, professional accountants in business are often faced with deciding which of these characteristics could be the most important, given a specific context, and judging the trade-offs between characteristics. One of the more difficult issues to deal with is bias (typically optimism bias) affecting information flows. Bias that is inherent in information that parts of the organization feed into a DCF analysis can influence decisions. It is important first to recognize bias, then to consider necessary adjustments in a DCF analysis to remove it where possible. Possible bias in forecasts is better addressed by adjusting cash flow estimates rather than the discount rate. Public and not-for-profit sector application
A. 8 Governments in some jurisdictions provide guidance to its public sector bodies and authorities on how to appraise proposals before committing significant funds. For example, the United Kingdom, United States, Australian, and New Zealand governments provide guidance (see resources at appendix A) on the issues and techniques that should be considered when assessing new regulatory, revenue or capital policies, programs, and projects.
Such guidance advises public sector departments and authorities how to undertake conventional DCF-based analysis to calculate NPV (and usually states that most assessments of potential investments require an NPV calculation). As in a commercial setting, the appropriate monetary yardstick for accepting an investment is normally based on a positive NPV, and/or an expected NPV that is higher than or equal to the expected NPV of mutually acceptable alternatives. However, such guidance can offer PROJECT APPRAISAL USING DISCOUNTED CASH FLOW 10 advice on a broader cost-benefit analysis that can be more valuable to the public interest, and in which NPV is only one tool.
A. 9 Cost-benefit analysis is broader than financial analysis, because it considers the potential benefits that flow outside the implementing organization or agency. As well as considering the strategic, financial, and economic case for a proposed investment, a cost benefit analysis could include a number of assessments that consider the potential impact on various stakeholder groups, such as society, the environment, consumers, and employees. This helps to establish the total welfare gain over the whole life of an investment. Non-monetary qualitatively based information can help to outweigh a
negative NPV in a project assessment, allowing a proposal to proceed.
A. 10 Investments to improve welfare usually generate benefits that (a) do not have a market price, and (b) are not easily measurable in monetary terms. Therefore, cost-effectiveness measures can be non-monetary units, supported by the use of ratios to link a financial appraisal to the non-monetary benefits arising from an investment. For example, in investing in vaccination programs to support the development of countries, non-monetary measures can include tests of efficiency and effectiveness, such as the number of people immunized, the number of people immunized per dollar (or other unit of currency) invested, and the cost per immunization.
The time value of money should be represented by the opportunity cost of capital.
B. 1 The opportunity cost of capital is fundamental to investment decisions, and is a significant input to a DCF analysis. Small changes in the discount rate may have a big impact on the NPV (and IRR) of a project. If the selected discount rate is too high, potentially good investment projects appear bad, and if too low, bad investments look attractive.
For example, a project with an initial investment of $800,000, and with annual cash flows of $500,000 over a 6-year period and a discount rate of 15 per cent will have an NPV of over $52,000 lower than if the project was considered with a discount rate of 14 per cent.
B. 2 Discounting cash flows reflects the time value of money, which assumes that (a) generally, people prefer to receive goods and services now rather than later (even in the absence of inflation), and (b) the promise of money in the future carries risk for which an issuer of security will require compensation.
To calculate present value, estimated future cash inflows and outflows should be discounted by a rate of return (commonly referred to as the discount rate) offered by comparable investment alternatives. In applying the cost of capital, professional accountants in business should consider the most appropriate method for determining present value. For risky cash flows, it is typical to discount expected value using a risk-adjusted discount rate (i. e. , adjusted for time and risk). However, an alternative approach is to use a certainty equivalent method that makes separate adjustments for risk and time.
Such an approach adjusts for the time value of money by using the risk-free rate to discount future cash flows, after converting uncertain PROJECT APPRAISAL USING DISCOUNTED CASH FLOW 11 cash flows into their certainty equivalents. Although not widely used in practice, this approach can be useful when risk varies over time, as it allows each period’s cash flows to be adjusted for their specific risks. However, it is important to recognize that, as this method does not involve a market-derived risk element, there will be subjectivity encountered by the decision maker in estimating the appropriate certainty equivalent.
B. 3 In calculating an organization-wide cost of capital, a rate of return is usually required for each form of capital component, whether it is derived from shareholders (equity) and/or lenders (debt). The cost of capital associated with investment and capital budgeting decisions is typically a weighted average of the various components’ costs – typically called the weighted average cost of capital (WACC). Determining the cost of equity capital can be particularly difficult, as the application of techniques such as the Capital Asset Pricing Model (CAPM) can be complex, and subject to a number of variations to reflect particular contexts. It should also be noted that where there is not an open market for securities, CAPM is not usually a useful approach to assess risk because of the difficulties of estimating beta.
B. 4 To provide organizations flexibility in applying and estimating the cost of capital, IAS 36 suggests that an organization could also take into account its incremental borrowing rate and other market borrowing rates. However, professional accountants in business should be aware of the disadvantages associated with these methods, and apply them appropriately given the organizational context.
For example, depending on the debtequity ratio, the cost of debt, the nominal borrowing rate, and the WACC will provide varying values, so that for a highly leveraged organization, the use of the incremental borrowing rate as the cost of capital could lead to an inappropriate estimate for value in use.
B. 5 When using CAPM or alternative techniques to estimate the cost of equity, professional accountants in business should be familiar with the financial theory that underpins them, and their implications for determining the cost of capital. For example, CAPM is based
on portfolio theory, which assumes that markets are efficiently priced to reflect greater return for greater risk, and that investors are perfectly diversified. This suggests that investors should only be compensated for systematic risks that affect their whole portfolio of shares. Therefore, although project- and organization-specific risks are important considerations in allocating resources, risks specific to an investment or a project should not be reflected in the discount rate, but rather in an adjustment to the cash flows of the investment or project. For example, diversification by organizations could increase value, but it should not be assumed that diversification will reduce the cost of capital. Reflecting risks in cash flows also enables managers to better assess how specific risks affect value, and therefore how to manage them. B. 6 Where applying CAPM and its beta coefficient, professional accountants in business should be familiar with the approaches that could be used to enhance their application. They include altering the period over which to measure beta, the frequency of observation, comparator analysis with industry sector betas, and choice of data provider.
Comparator analysis, which averages betas across a selection of comparator/peer PROJECT APPRAISAL USING DISCOUNTED CASH FLOW 12 companies, can sometimes help estimate betas for organizations not listed on a stock exchange. It could also be necessary to consider how changing capital structures affect expected returns and beta.
The discount rate used to calculate the NPV in a DCF analysis should properly reflect the systematic risk of cash flows attributable to the project being appraised, and not the systematic risk of the organization undertaking the project.
C. 1 The discount rate an organization uses to assess an investment opportunity should be calculated separately, and should not necessarily be the same as the overall cost of capital for the organization. A potential investment with a high systematic risk will always be risky, irrespective of the investor or the organization. An organization with a perceived lower risk should not use its overall cost of capital to appraise an investment that is potentially more risky. Although an organization-wide cost of capital could be the starting point for considering discount rates for project risk, it can only be considered an appropriate discount rate for projects that have the same risk as an organization’s existing business.
C. 2 Organizations considering an investment with high specific risks often use a high investment hurdle rate rather than using the discount rate, therefore departing from a lower cost of capital that is calculated using the portfolio approach. There is no theoretical basis for setting a very high hurdle rate to compensate for high specific risk or a risk of failure. It is a matter of judgment, which can be supported by calculating the probability-weighted expected value of cash flows of an investment. This could be achieved by (a) developing several scenarios, and (b) assigning them probabilities of realization (including a probability of a project failure if applicable) – link to principle G. Organizations should be aware of the potential behavioral issues that can arise where an investment hurdle is higher than the cost of capital for a project. In some situations, it could encourage bias in projections and skew investments towards higher risk projects.
A good decision relies on an understanding of the business and an appropriate DCF methodology. DCF analysis should be considered and interpreted in relation to an
organization’s strategy, and its economic and competitive position.
D. 1 It is important to realize that decisions, especially those taken in a relatively high-risk environment, involve cash flow estimates based on judgment. Hard and fast cash flows do not exist. DCF analysis should probe behind cash flow estimates to understand both the nature of a positive NPV, and the source of value over the opportunity cost of capital.
D. 2 The NPV is only one criterion that supports an evaluation of a potential investment. It should be coupled with a review of (a) the investment’s strategic importance, or (b) its alignment with the strategic themes and objectives that have been outlined in a strategic plan and/or in a balanced scorecard-type framework.
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D. 3 Discussions and judgments on an organization’s competitive environment and competitive position could contribute to (a) an understanding of whether an asset might be more valuable in the hands of another, and (b) highlighting significant forecasting and assumption errors. DCF analysis is most useful in evaluating an organization’s strategic position, so that sources of competitive advantage can be better understood.
Describing competitive advantage, such as by identifying superior customer value through product attributes and price, can improve the quality and relevance of financial forecasting.
Cash flows should be estimated incrementally, so that a DCF analysis should only consider expected cash flows that could change if the proposed investment is implemented. The value of an investment depends on all the additional and relevant cash inflows and outflows that follow from accepting an investment.
E. 1 Organizational strategy and business planning typically produces a range of investment
options, some of which could need consideration and review. Each option can be appraised by establishing a base case that reflects the best estimate of its costs and benefits, and from which incremental cash flows can be estimated. These estimates can be adjusted by considering different scenarios, or the option’s sensitivity to changes can be modeled by changing key variables. It is usually helpful to determine which variables lead to a different outcome for a base case and each option, and it could be useful to invest time to quantify these. A focus on incremental cash flows allows an analysis of the effect of a make or buy decision. In deciding whether to make or buy components or replace machinery, for example, the increased costs associated with the purchase and installation of new machinery/technology should be weighed against the savings.
E. 2 DCF analysis models after-tax cash flows arising from the investment. Only cash flow is relevant in DCF analysis, not accounting net income. Forecast profit and loss accounts should be converted into cash flow (earnings are usually reported on an accrual basis according to generally accepted accounting principles). Adjustments to profit to derive cash flow include (a) adding back depreciation, (b) reflecting changes in working capital, and (c) deducting future capital expenditures. Therefore, the cash flow effect of investment in inventories can be measured by considering whether additional cash has been required at the beginning or end of a year. If cash was released by depleting inventory, the resulting cash flow effect is positive. Working capital is a typical cash outflow at the beginning of a project, as more cash is required at the beginning of a new investment project. Liquidating working capital at the end of an investment project usually produces a cash inflow.
E. 3 At any decision-making point, only cash flows that arise in period 0 (period of initial investment) and in subsequent periods should be considered relevant in appraising projects. Incremental cash flow equals cash flow for an organization with the project, less cash flow for the organization without the project. Comparing a potential investment against declining to do it facilitates an understanding of the benefits from making the PROJECT APPRAISAL USING DISCOUNTED CASH FLOW 14 investment. DCF analysis is typically based on years, but it can be conducted based on shorter time periods, such as months or quarters.
E.4 Inflation should be considered in investment appraisal and DCF analysis. It affects cash flows, and could be significant. Inflation reduces the purchasing power of net cash flows over time. Inflation should be properly reflected in the nominal discount rate with a riskfree component of a formula; it should also be reflected in the projected cash flows, because projecting cash flows in real terms will make it impossible to properly state cash outflows related to tax payments.