Market predictions based on the earlier data and on the actual sales are made, using techniques such as time series analysis and moving averages. There are also predictions from the buyers' surveys, and from the company staff as a result of their experience in the launch. Comparing all these predictions is a good basis for forecasting the pessimistic, most likely and optimistic sales potentials for the next five years with their associated probabilities of achievement. The net present value, or the return on investment, can be calculated using discounted cash flows.

Very simple examples of payback time analysis and net present values are shown in Tables 7.2 and 7.3.

There are two predictions in Table 7.2, one made before the launch and one two months after the launch, to show how predictions need to be updated when actual sales and costs are available. The payback period is defined as the length of time required to recover the cost of the project. This is useful to control the cash flows but it is not helpful in choosing the project in the first place, as a project with long-term profits could be dropped.

To take into account the timing of the investment, costs and profits, discounted cash flows are used as in Table 7.3. Timing has a direct bearing on the profitability of the project. The objective of discounted cash flows (DCF) is to relate cash flows arising from the project to a common base year, normally the present; hence the name 'net present value’ (NPV). For a project, the discounted investments are subtracted from the discounted earnings to give the present value of the project as shown in Table 7.3.

Table 7.2 Predicted payback period for new product ‘A’

Prediction Before launch Actual Two months after launch Project cost up to launch 400,000             380,000             Launch costs 2,000,000             2,500,000             Profits 350,000             250,000               Prediction Before launch Prediction Two months after launch Profits per 2 month     4 months after launch 500,000             400,000             6 months after launch 600,000             500,000             8 months after launch 600,000             600,000             10 months after launch 700,000             700,000             12 months after launch 800,000             800,000             Total profit after 1 year 3,550,000             3,250,000                   Pay back period     Project costs ~3 months             ~4 months             Project + launch costs ~9 months             ~11 months

Table 7.3 Predicted cash flows and present value for new product ‘B’

Years after introduction Total   0 1 2 3 4 5   Investment*     Actual 6.0 1   Present value factorsa - 0.93   Present value 6.0 0.9 6.9 Earnings     Revenue 0 2 4.5 6.0 4.5 2.5   Costs 0 2.1 1.5 2.0 1.8 1.5   Cash flow 0 -0.1 3.0 4.0 2.3 1.0   Present value factorsb 0 0..89 0.80 0.71 0.64 0.57   Present value 0 -0.1 2.4 2.8 1.5 0.6 7.2   Net present value 0.3 *Values are millions of dollars. Interest rate: for a investment 8%, and for b earnings12%.

The computation uses present value factors, which are calculated for various rates of return.

Present value = future value/(1+i)ⁿ where i is the interest rate and n the number of years; 1/(1+i)ⁿ is known as the discount factor.

In Table 7.3, 12% was used and the factors calculated using this gave a positive net present value, showing the project returned more than 12%. The actual DCF rate of return can be calculated by finding the rate where the earnings and the investment cash flows are equal, i.e. profits will just pay back the capital and the interest over the life of the project.

Think Break 7.5 Financial evaluation: DCF rate of return Using the cash flow in Table 7.3, calculate the present values at different interest rates using the following present value factors. Year 0 1 2 3 4 5 Interest rate           10% 1.0 0.9091 0.8264 0.7513 0.6830 0.6209 11% 1.0 0.9009 0.8116 0.7312 0.6587 0.5935 12% 1.0 0.8913 0.7972 0.7118 0.6355 0.5674 13% 1.0 0.8850 0.7831 0.6931 0.6133 0.5426 14% 1.0 0.8772 0.7695 0.6750 0.5921 0.5194 1. Determine the actual DCF rate of return. 2. If the investment in year 1 was $2 million dollars instead of $1 million, what would be the DCF rate of return?