Discounted Cash Flow Valuation

Question 1

How is the future value of a single cash flow computed?

Answer 1

• When there is only one cash flow in one period, we calculate FV as:
• Co * (1+r), where Co is the cash flow today and r is the interest rate
• When there is more than one period, we calculate FV as:
  Co *(1+r)^t, where Co is the cash flow today, r is the interest rate and t is the periods

Question 2

How is the present value of a series of cash flows computed.

Answer 2

• The present value is todays value of a sum to be received in the future given a specific rate of interest and time horizon
• When there is only one period, we calculate PV as:
  PV = C1 / 1+r, where C1 is cash flow at date 1 and r is the interest rate
• When there are more than one period, we calculate PV as:
  PV = Ct / (1+r)^t where Ct is cash flow at date t, r is the interest date and t is the periods

Question 3

What is the Net Present Value of an investment?

Answer 3

• The Net Present Value of an investment is the present value of excpected cash flows, minus the cost of the investment
• We calculate it as NPV = -cost + PV

Question 4

What is an EAR, and how is it computed?

Answer 4

• The Effective Annual Rate (EAR) of interest is the annual rate that would give us the same end-of-investment wealth after X years
• It is computed as FV *(1+Ear)^t

Question 5

What is a perpetuity? An annuity?

Answer 5

• A perpetuity is a constant stream of cash flow that lasts forever
• Its computed as PV = C/r
• An annuity is a constant stream of cash flows with a fixed annuity
• Its computed as: C/r *(1-(1/(1+r)^t))

Question 6

Contrast interest-only loans to amortized loans.

Answer 6

• Interest only loans requires an interest payment each period, will full principal due at maturity vs Amortized loans require repayment of principal over time, in addition to required interest