Discounted Cash Flows Flashcards
The present value of expected cash inflows associated with the project, less the present value of the projects expected cash outflows, discounted at appropriate cost of capital.
Net Present Value
*The PV of all cash flows minus the initial outlay at time t==0.
Net Present Value Formula
NPV = SUM(CFt/(1+r)^t)
CFt = The expected net cash flow at time t N = life of the investment r = discount rate (opportunity cost of capital)
The rate of return that equates the PV of an investments inflows with the PV of its outflows OR the discount rate for which the NPV of an investment in zero.
Internal Rate of Return
NPV Decision Rule
If NPV > 0, accept project, reject if NPV <0.
*When 2 projects are mutually exclusive and only 1 can be accepted, choose the project with the highest NPV.
IRR Decision Rule
If IRR > the investors required rate of return, accept projects.
Issues with the IRR Method
If initial costs are different sizes or the timing of CFs are different, the NPV and IRR rule can conflict. In this case, always select the project that will create the most wealth for shareholders.
The percentage change in the value of an investment over the period which it is held.
Holding Period Yield
The holding period return plus cash flows associated with the asset, such as, dividends or interest payments.
Total Return
Holding Period Return Equation
(Ending Value / Beginning Value) -1
The IRR of a portfolio taking into account all cash inflows and outflows.
PVinflow == PVoutflow
Money-weighted return
*beginning value + deposits = inflow
ending value + withdrawals + dividends = outflow
The rate at which $1 compounds over a specific performance horizon.
Time-weighted rate of return
Time-weighted Rate of Return Formula
SUM((1+HPRa)…(1+HPRz))
If the total investment period is more than 1 year, the annual time weighted rate of return must be calculated by taking the geometric mean of the measurement period return
**Time weighted RoR is preferred to Money-weighted RoR because it is not affected by the timing of cash inflows and outflows.
Bank Discount Yield (BDY) Formula:
- T-bills are quoted on a bank discount basis
r = (D/F) *(360/t)
r = annualized yield on a bank discount basis D = the dollar discount, which is equal to the difference between the face value & purchase price F = Face Value (Par Value) of the bill t = number of days until maturity 360 = bank convention for days/year
Bank Discount Yield is not representativeof the return by an investor for the following reasons:
BDY uses simple interest rate and not the compounding interest rate.
BDY is at face value, not purchase price
BDY is based on a 360 day year, not a 365 day year.
