Discounted Cash Flow Flashcards
What is meant by simple interest?
Interest accrues only on the initial amount invested
What is meant by compound interest?
Interest is reinvested alongside the principal
What is meant by EAIR?
Interest is charged on a non-annual basis
When is it necessary to know the EAIR?
Interest on bank overdrafts (and credit cards) is often charged on a monthly basis
The more frequent the compounding methods in EAIR?
The higher the EAIR is
A discount factor for a cash flow arising now?
The discount factor is always one
The main assumption for TVM?
Investors prefer to receive $1 today rather than $1 in one year
Liquidity preference for TVM?
If money is received today it can either be spent or reinvested to earn more in future
Risk for TVM?
Cash received today is safe, future cash receipts may be uncertain.
Inflation for TVM?
Cash today can be spent at today’s prices but the value of future cash flows may be eroded by inflation
Two methods for DCF?
NPV (absolute measure)
IRR (relative measure)
Advantage of DCF (Take into account)
tThe time value of money
All of a project’s cash flows over its entire duration; and
the timing of cash flows
Advantage of DCF (Objective basis)
Provide a more objective basis for evaluating and selecting investment projects as they are not affected by financial accounting policies
Disadvantage of the DCF methods?
Complexity of estimating appropriate discount rate
Complex calculation
What does a project’s NPV show?
The theoretical change in the dollar value of the company due to the project
What if positive NPV projects are accepted?
Shareholder wealth is therefore increased
What is an annuity?
A stream of identical cash flows arising each year for a finite period of time.
What is a perpetuity?
A stream of identical cash flows arising each year to infinity.
What does IRR represent?
The average annual percentage return from a project and therefore shows the highest finance cost that can be accepted for the project
If IRR > Cost of capital
Accept project
If IRR < Cost of capital
Reject project
What must be given for an NPV to be zero?
The present value of the cash inflows must equal the initial cash outflow
What happens if cash outflows are followed by cash inflows and then more cash outflows?
The situation of “multiple yields” may arise
If NPV > 0?
Accept
If NPV < 0?
Reject
What does NPV show?
Dollar change in value of company/wealth of shareholders
What is an absolute measure?
$
What is a relative measure?
%
If IRR > target %
Accept
If IRR < target %
Reject
Can IRR have multiple answers?
Yes
Is NPV better than IRR
Yes as it’s absolute, takes into account size of project
