Chapter 3 - Investment appraisal - Discounted cash flow techniques Flashcards
What are the 3 reasons for time value of money?
- Consumption preferences
- Inflation
- Risk
What is time value of money?
A unit of money obtained today is worth more than a unit of money obtained in the future
What is consumption preference?
Would rather have the money today than in a yearWhat
What is purchasing power?
e.g., when a car you might want to purchase now may cost more in the future. This would be a loss of purchasing power
What is compounding?
Calculates the future (or terminal) value of a given sum invested today for a particular time period at a particular rate of interest.
What is the calculation for compounding?
F = P(1 + r) n (power)
F= Future value
P= Initial investment (present value)
r= Interest rate
n= number of time periods
What is discounting?
Performs the opposite of compounding. Calculates the present value of an amount received or paid in the future.
What is the present value (PV)?
Present value is the cash equivalent now of money receivable/payable at some future date.
What is the formula for discounting?
Present value (P) = Future value (F) x (1 + r ) -n (power of)
When discounting we use the rate of interest what are the other terms?
- cost of capital
- discount rate
- required return
What is Net present value (NPV)?
Discount all the relevant cash flows for a project back to their present values. With cash outflows as negative and cash inflows as positive, ass up all the present values to determine the NPV.
what the NPV is negative what will this mean for the project?
not financially viable
what the NPV is positive what will this mean for the project?
financially viable
what the NPV is zero what will this mean for the project?
breaks even
The rate of interest used for discounting reflects what?
the cost of the finance that will be tied up in the investment
If company as 2 or more mutually exclusive projects under consideration, which one should it choose?
One with the highest NPV
The NPV gives what?
The impact of the project on shareholder wealth
The assumption used in discounting regarding when cash flows occur is what?
- all cash flows occur at the start or end of a year
The assumption used in discounting regarding when the initial investment occurs is what?
occur at time period 0 (t0)
The assumption used in discounting regarding other cash flows occur is what?
other cash flows start one year after that (t1)
The assumption used in discounting regarding interest cash flows on funding is what?
do not include interest cash flows on funding (already taken into account within the cost of capital used)
What are some advantages of NPV?
Does consider the time value of money
A measure of absolute profitability
Considers cash flow
Considers whole life of the project
Can easily account for risk
Maximises shareholder wealth
What are some disadvantages of NPV?
Fairly complex
Not well understood by non-financial managers
It may be difficult to determine the cost of capital
Only considers the long-term, so may lead to short-term demotivation
What is annuity?
constant annual cash flow for a number of years
What is perpetuity?
annual cash flow that occurs forever.
What is the calculation for present value of an annuity?
PV = Annual cash flow x annuity factor (AF)
What is the annuity factor?
the name given to the sum of the individual discount factors covering the period of the annuity.
What is the calculation of the annuity factor?
1 - (1+r)-n (power) / r
What is the calculation of the present value of perpetuity?
PV = Annual cash flow x perpetuity factor
The perpetuity factor can be calculated as what?
1 / r
For perpetuities whose cash value grows at a constant rate, the perpetuity factor that should be used is what?
1 / (r-g)
g = growth rate
What is advanced annuity or perpetuity?
If cash flow starts at t0
What is delayed annuity or perpetuity?
If cash flow starts at a time period later than t1
What is the IRR?
Internal rate of return represents the discount rate at which the NPV of an investment is zero. As such represents a breakeven cost of capital
When should projects be accepted when calculating the IRR?
when greater than the cost of capital
How is the IRR calculated?
using linear interpolation.
- calculate two NPVs for a project at 2 different costs of capital
IRR = L + ((Nl / (Nl - Nh) (H-L))
L= lower discount rate
H=higher discount rate
Nl = NPV at the lower discount rate
Nh = NPV at the higher discount rate
What are some advantages of IRR?
Considers time value of money
Easily understood
Considers cash flows
Considers whole life of project
Can be calculated without reference to cost of capital
What are some disadvantages of IRR?
Doesn’t measure absolute profitability
Linear interpolation is only an estimate
Relatively complicated to calculate
If IRR and NPV are in conflict what should be used?
NPV
