Where in an NPV cash flow analysis do you insert further equity investment beyond Yr 0 and is it plus or minus?

Where in an NPV cash flow analysis do you insert further equity investment beyond Yr 0 and is it plus or minus?

I am looking at a Capital Investment Appraisal question and money to fund the project (an MBO) is obtained from both equity and bank borrowings. In the middle of the project (years 2 and 3) more cash is needed which is provided by the shareholders. How is this extra funding shown which actually enhances the cashflow but is an investment like the Year 0 one which is a minus figure ? Is the additional money poured in negative (from the investor's viewpoint) or is it positive (from the cashflow viewpoint).

Ans:

Generally, the additional capital is considered to finance the negative CF of that period - i.e. the negative amount that gives rise to the need to raise (and contribute to the project) additional capital.
So THAT add'l capital is not a cash flow of the project, it is simply considered to be available to FINANCE the negative cash flows that I assume appear in years 2 & 3.



Consider...
When the net CF is goes negative, than at that stage the company owes money, so a high discount rate is not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial investment, that is, explicitly calculate the cost of financing such losses. In your case, the cost to finance the losses is the cost (the required return) of the NEW equity raised for the project.

If you account for the cost of the new equity this way, you wouldn't change the discount rate to reflect the new capital structure because this would be double counting the cost of the new equity.
Example: r = begining discount rate
ke = cost of new equity
Basic CFs of the project (no new equity) ....(CFYr2)/(1+r)^2 + (CFYr2)/(1+r)^3....
above shows base negative CFs from the cash flow..add to year3's base cost (- i.e. increase the negative amount by), the cost of the new equity required to finance the base negative CF in year 2. In year 4 (which I assume by this time is positive) account for the costs of financing the base negative amounts in years 2 and 3. (I am assuming that the amount of add'l equity raised is equal to the sum of the 2 base negative years.) The cost of this financing continues for the remaining years of the project (unless you buy back the new equity out of those cash flows <unlikely.)

Again, don't change the discount rate or you'll be double counting.

Example:
CF2base = (10,000)
CF3base = (8,000)
CF4base = 6,000
Add'l equity req'd yr 2 = 10,000 * (ke) rate new equity, say 8% = add add'l $800 expense to CF3 before discounting
Add'l equity req'd yr 3 = 8,000 * 0.08 = $640 (+previous $800)=add add'l expense of $1440 to CF4 AND ALL subsequent CFs before discounting
Adjusted CFs to discount:
CF3 = (8,800)
CF4 = 4,560
etc.

Hope this helps....

Source(s):

http://en.wikipedia.org/wiki/Net_present…