Finance Tools to evaluate a project's worth - DCF, NPV, IRR, Hurdle rate

JWI 530, Financial Management I, week7 summary, 2/24/13

1. Evaluate if a project is worthy of investment
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Understand time value of money: estimate future value with projected cash flows, required rate of return, hurdle rate. To determine potential ROI for various project choices, use Discounted Cash Flow (DCF), Net Present Value (NPV), IRR.

DCF
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The true value of a project is the sum of its discounted future cash flows.
DCF helps calculate the returns for an investment and how long it will take for getting the returns

NPV
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NPV is  a component of the DCF - it is another metric used to assess the profitability of a project
It is simply the difference between the present values of cash inflows and cash outflows of a project.
It is a type of discounted cash flow analysis, usually applied to a specific capital project, which involves an initial and immediate cash outflow
followed by a string of net cash inflows.
If NPV>0, then Rate of Return (RoR) >= hurdle rate => better off selecting the project
If NPV<0, then Rate of Return (RoR) < hurdle rate => better to reject the project

IRR
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IRR is the discount rate that makes the project's NPV equal to zero.
If IRR >hurdle rate, accept the project
If IRR<hurdle rate, reject the project

2. How does discount rate influence the overall financial strategy of the organization?
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Vision, Mission, Strategy, Structure, Process
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After a firm has defined its vision and mission (with objectives and scope),  planning for strategy, operations and finance begins.
A strategic plan provides clarity about the big a-ha (Welch, 2005) - a unique and differentiated competitive position in the marketplace,
and a vision of what the firm's top management expects (brigham, ehrhardt, 2011).

Financial plan
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The financial plan is the fuel that propels the firm's strategy and typically involves five steps:
(1) forecast financial statements under alternative versions of the operating plan and sales projections
(2) determine the amount of capital needed to support the plan
(3) forecast funds that will be generated internally and funds to be raised through external financing
(4) establish performance based management compensation system
(5) monitor operations to spot deviations and take corrective actions

Risk
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Business risk is the variability in the projected earnings due to the inherent risks in carrying out the firm's operations.
Due to the risk involved for the financial investment, shareholders expect to be compensated with a high enough rate of return which is known as the discount rate.

3. Factors in choosing a discount rate
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Discount rate is also known as the risk premium or expected rate of return.
Discount rate is a trade-off between risks and returns. Higher the risk, higher the expected rate of return while risk averse investors will forego high risk projects.

Discount rate = Risk free rate + beta (equity market risk premium)

To choose the appropriate discount rate for projects, investors and financial managers would ask:
(1) how mature is the company that is seeking investment ? - is the leadership trust worthy and committed for long run ?
(2) what are the risks involved in the market, firm and the project ? - is the industry structure attractive to invest ?
(3) what are the expected rates of return ?
(4) does the rate of return compensate adequately for the risks ?
(5) what are the bounds - the worst case, nominal case and best case scenarios for projected cash flows ?
(6) How much risk is acceptable for the firm to take ? - how badly does the firm want to proceed with the project ?
(7) what is the opportunity cost of proceeding with the project or not proceeding with the project? (every project is only as good as its next best alternative)

Dr DP