a) Briefly state what you understand by discounted cash flows and explain why, in appraising capital investments, it is necessary to discount cash flows?

Discounted cash flows are cash flows that are to be received in the future and are discounted to give them a present or current value. Discounted cash flow methods (DCF) are capital appraisal techniques that account for the fact that €1 earned or spent sooner, is worth more than €1 earned or spent later. The earlier positive cash flows are generated, the sooner they can be used to make a further contribution to profit. Thus the time value of money concept plays an important role in appraising capital projects because the time lag between the initial investment and payback can be quite long. However the difficulty lies in comparing €1 cash flow received today with €1 received in the future, as the two cannot be equal to each other given they are received in different time periods. Thus to evaluate any project taking into account the time value of money, the cash flows received in the future must be reduced or discounted to a present value, so that all relevant cash flows are denominated in todays value (present value). This discount factor represents the cost of waiting, or the time value of money. 

b) Distinguish between the net present value and the internal rate of return methods of capital investment appraisal. You should explain why the net present value method is preferred to the internal rate of return method

The net present value approach involves discounting all cash outflows and inflows of a capital investment project at a chosen target rate of return or cost of capital. The present value of the cash inflows minus the present value of the cash outflows is the net present value. If the NPV is positive, the project is likely to be profitable, whereas if the NPV is negative, the project is likely to be unprofitable. Its main advantages are

q     It takes into account the time value of money.

q     Profit and the difficulties of profit measurement are excluded.

q     Using cash flows emphasis’s the importance of liquidity.

q     It is easy to compare the NPV of different projects.

The main disadvantage associated with this method is that it is not as easily understood as the payback and accounting rate of return. Also, the net present value approach requires knowledge of the company’s cost of capital, which is difficult to calculate.

The IRR method calculates the exact rate of return which the project is expected to achieve based on the projected cash flows. The IRR is the discount factor which will have the effect of producing a NPV of 0. It is the return from the project, taking into account the time value of money. Its decision rule is to accept the project if it’s IRR is greater than the cost of capital. It main advantage is that the information it provides is more easily understood by managers, especially non-financial managers. Its main disadvantages are

q     It is possible to calculate more than two different IRR’s for a project. This occurs where the cash flows over the life of the project are a combination of positive and negative values. Under these circumstances it is not easy to identify the real IRR and the method should be avoided.

q     In certain circumstances the IRR and the NPV can give conflicting results. This occurs because the IRR ignores the relative size of investments as it is based on a percentage return rather than the cash value of the return. As a result, when considering 2 projects, one may give an IRR of 10 per cent and the other an IRR of 13 per cent. However the project with the lower IRR may yield a higher NPV in cash terms and thus would be preferable.

It is for these reasons that the NPV method is preferred to the IRR approach especially when comparing mutually exclusive investments.