15.7 Discounted cash flow techniques based on the time value of money

Question 1

What three discount cash flow (DCF) methods could be used to evaluate projects?

Answer 1

1 Net present value (NPV)
2 Internal rate of return (IRR)
3 Discounted payback period

Question 2

What is meant by “the time value of money”?

Answer 2

The concept that money today is worth more than the same sum received in future.

Question 3

Why does the value of money increase over time?

Answer 3

• potential interest earned on investments
• payment of debts now to avoid interest later
• impact of inflation
• effect of risk (i.e. future transactions may be uncertain whereas cash in the bank now is definitive.

Question 4

What is “Compounding”?

Answer 4

The process of determining the future value of present investment or cash flows by considering interests that can be earned on the amounts invested today.

Question 5

What is the formula for compounding?

Answer 5

FV = PV (1+r)^n

Where
FV = future value
PV = present value
r - rate of compound interest
n = number of years

Question 6

What is meant by “discounting” when considering the time value of money?

Answer 6

The opposite of compounding - i.e. the process of determining the present value of cash flows based on the future value by using discounting rates.

Question 7

What is a “discount rate”?

Answer 7

The rate of return used in discounted cash flow analysis to determine the present value of future cash flows.

Question 8

What is the formula for for discounting?

Answer 8

PV = FV / (1+r)^n

Where
FV = future value
PV = present value
r - rate of compound interest
n = number of years

Question 9

What is meant by “present value factor”?

Answer 9

The current value today per £1 received at a future date.