Discounted Cash
Flow Techniques
Time value of Money
Money received today is worth more than the same sum received in the
future, i.e. it has a time value.
This occurs for three reasons:
● Liquidity preference: money received today can be spent or
reinvested to earn more. Therefore, investors have a preference for
having cash/liquidity today.
● Risk: cash received today is safe; future cash receipts may be uncertain.
● Inflation: cash today can be spent at today's prices, but the value of
future cash flows may be eroded by inflation.
Simple and compound interest
● Simple interest - Interest accrues only on the initial amount invested.
● Compound Interest - Interest is reinvested alongside the principal.
Compounding and Discounting
● Compounding calculates the future or terminal value of a
given sum invested today for a number of years.
F = P * (1+r)^n
● Discounting is the method to calculate present value which
is the cash equivalent now of money receivable/payable at
some future date
P= F* (1+r)^-n
Effective annual interest rates
Where interest is charged on a non-annual basis, it is useful to know the effective
annual interest rate (EAIR). For example, interest on bank overdrafts (and credit
cards) is often charged monthly. To compare the cost of finance to other sources,
it is necessary to know the EAIR
R = (1+i)^n - 1
R = Effective annual interest rate
i = interest for the compounding period
n = Number of compounding period
Synonyms of Rate of Interest
Cost of capital
Discount rate
Required return
Net Present Value
● NPV of the project is the sum of the PVs of all cash flows that arise
as a result of doing the project.
● if the NPV is positive – the project is financially viable
● if the NPV is zero – the project breaks even (just returning enough
money to cover the funding costs)
● if the NPV is negative – the project is not financially viable
● if the company has two or more mutually exclusive projects under
consideration it should choose the one with the highest NPV
● Assumption of NPV - Surplus cash flows are reinvested at the
minimum required rate of return.
NPV and shareholder wealth
● The main objective of financial management is to maximise shareholder wealth.
Shareholder wealth is increased if projects with positive NPVs are accepted, and
shareholder wealth will be maximised if a company invests in all such projects
● In other words, if the NPV of a project is $1m, the company's market value will
increase by $1m, and shareholder wealth will increase by $1m
Therefore, NPV is considered the superior technique in business decision making.
Assumptions used in Discounting
All cash flows occur at the start or end of a year
Initial investments occur at T0 (today)
Other operating cash flows start one year after that (T1).
Never include interest payments (financing cash flows) as cash
flows within an NPV calculation as these are taken account of by
the cost of capital.
Advantages and Disadvantages of NPV
Advantages Disadvantages
● considers the time value of ● It is difficult to explain to
money managers
● is an absolute measure of ● It requires knowledge of the
return cost of capital
● is based on cash flows, not ● It is relatively complex.
profits
● considers the whole life of the
project
● should lead to maximisation of
shareholder wealth.
Annuities and Perpetuities
● An annuity is a constant annual cash flow for a number of years starting
from one year time.
PV = Annual cash flow * Annuity Factor
● A perpetuity is an annual cash flow that occurs forever starting from one
year time.
● Present value of a growing perpetuity
Advanced annuities and perpetuities
Some regular cash flows may start now (at T0) rather than in one year's time
(T1).
Calculate the PV by ignoring the payment at T0 when considering the number
of
cash flows and then adding same cash flow to the Present value.
Delayed annuities and perpetuities
Some regular cash flows may start later than T1.
These are dealt with by:
(1) applying the appropriate factor to the cash flow as normal
(2) discounting your answer back to T0 by multiplying with the DF of
previous year
Internal Rate of Return
The IRR is the discount rate at which the NPV of an investment is
zero (Break even cost of capital)
Accept the project if IRR is greater than the cost of capital.
Anything that increases the return on the project would increase the
IRR.
The IRR may be calculated by a linear interpolation.
To calculate the exact IRR requires a more complex technique, best
carried out using a spreadsheet.
Contains an inherent assumption that cash returned from the project
will be re-invested at the project’s IRR, which may be unrealistic.
Calculation of IRR - Interpolation Method
IRR of Annuities and Perpetuities
IRR of an Annuity
● Find the AF as Initial investment ÷ Annual inflow
● Find the life of the project, n.
● Look along the n year row of the AF until the closest value is found.
● The column in which this figure is found is the IRR
Non conventional cash flows
Advantages of IRR
● considers the time value of money
● is a percentage (relative measure) and therefore easily understood
● uses cash flows not profits
● considers the whole life of the project
● means a firm selecting projects where the IRR exceeds the cost of
capital should increase shareholders' wealth
Disadvantages of IRR
● It is not a measure of absolute profitability.
● Interpolation only provides an estimate and an accurate estimate
requires the use of a spreadsheet programme.
● It is fairly complicated to calculate.
● Non-conventional cash flows may give rise to multiple IRRs, which
means the interpolation method can't be used. (Zero, One, two)
● Contains an inherent assumption that cash returned from the project
will be re-invested at the project’s IRR, which may be unrealistic.
Why NPV is superior than IRR?
The advantage of NPV is that it tells us the absolute increase in
shareholder wealth as a result of accepting the project, at the current cost
of capital.
As a relative measure, IRR takes NO account of the relative size of a project;
therefore, it cannot be relied on when making choices
assumption in the IRR model that the interim cash flow receipts can be
reinvested at the IRR. Therefore, an IRR that is significantly higher than a
realistic reinvestment rate will be an overestimate of the project’s actual
return.
Non conventional cash flow issues when using IRR
