Reading 7: Discounted Cash Flow Applications Flashcards
Introductory Concepts: Understanding the Additive Principle for Cash Flows. What is the additive principle?
The additive principle is the principle that says that when calculating the present value of cash flows, you have to sum up the cash flows taking into account the discount rate/ interest rate and time value of the dollar.
PV= ***sum of all CF/[(1+R)^yr]
LOS 7a: Calculate & interpret the NPV & IRR of an investment.
INTRO:
So, when we talk about discounted cash flow applications, we are talking about 2 things. What are we talking about?
Discounted Cash Flows (INVESTMENT VALUATION METHOD) are important for 2 major reasons:
- ) INVESTOR- because the investor needs to know if based on the ‘discounted’ cash flows through IRR analysis and NPV analysis if the investment will “MAKE SENSE.”
- ) CAPITAL BUDGETING- when you look at J&J and its Listerine Products, the board of directors have to believe or be convinced that the product is going to produce returns for them. If it does not produce returns, then you will not see the product advertised on the website.
- CAPITAL BUDGETING IS A MICRO ASPECT THAT IS CONSIDERED BEFORE DISCOUNTED CASH FLOWS ARE TAKEN INTO ACCOUNT.
- YOU NEED TO SEE THE INCOME AND EXPENSES AND CREATE A NET OPERATING INCOME BEFORE YOU CAN DISCOUNT A CASH FLOW *****
**IN THIS INTRO, we will see the application of the investor’s mindset towards seeing if an investment is worth while!!!!!
LOS 7a: Calculate & interpret the NPV & IRR of an investment.
Understand the meaning of NPV & IRR.
Net Present Value- answers the question, “Is a dollar today, worth the same as a dollar tomorrow?”
Internal Rate of Return= calculates the rate at which the initial investment EQUALS the sum of all of the cash flows!
**What answer does it solve? It answers the question, “Is it risky to invest in my dollar today for the future?”
LOS 7a: Calculate & interpret the NPV & IRR of an investment.
What is the equation for the NPV?
The:
NPV= sum [CF/(1+wacc)^yr]
WACC= weighted average cost of capital/ usually used as a percentage/ rate of return
***For the NPV, you also need to take into consideration the initial INVESTMENT OF MONEY
LOS 7a: Calculate & interpret the NPV & IRR of an investment.
Where did J&J get its capital to invest in Listerine Product line?
J&J received its funds from the INVESTORS:
- ) board of directors/ shareholders
- ) banks
- ) lenders
***They had to convince all of these people that their product line would create a profit for the investors!
LOS 7a: Calculate & interpret the NPV & IRR of an investment.
So why do we use WACC as the required rate of return for an investment when calculating NPV?
We use WACC because it is derived from the BALANCE SHEET/ HEALTH OF THE COMPANY.
WACC= [cost of equity(% equity)] + [cost of debt(%liabilities)(1- tax rate)] + [(cost of preferred stock)(%preferred stock)]
% Equity= EQUITY/ ASSETS
% DEBT= LIABILITIES/ ASSETS
% PREFERRED STOCK= PREFERRED STOCK/TOTAL STOCK
LOS 7a: Calculate & interpret the NPV & IRR of an investment.
Once you calculate the NPV & IRR, how do you evaluate if an investment will be profitable or not?
NPV- the NPV has to be greater than 0 to invest.
IRR- The Internal rate of return has to be greater than the WACC to invest.
** WACC < IRR, then an investor should invest
LOS 7.b: Contrasting the NPV rule to the IRR rule & identify problems associated with the IRR Rule.
When to use the NPV or IRR rules->
a.) independent events - (NPV vs IRR)
- And you are NOT deciding between investments,
then its ok to go ahead and proceed with either
valuation method.
b.) mutually exclusive- (NPV vs. IRR)
- Then you should use NPV because you are
deciding between 2 separate investment.
- The GOAL of FINANCE/BUSINESS- IS TO
INCREASE SHAREHOLDERS WEALTH
- NPV does that DIRECTLY. (it gives you your profit
when you calculate.)
*** the size of the cash flow is directly related to the
NPV
LOS 7.c: Calculate and interpret holding period returns.
Holding Period Returns (HPR)= the way I see holding period returns is through an investment on etrade.
***If I wanted to see what the HPR was for my investment. What I would do is calculate with this formula:
a.) HPR= (final price- initial price + dividends)/ (initial
price)
b.) HPR= (P1-P0 +D)/ (P0)
LOS 7.d) Calculate & compare the money-weighted & time-weighted rates of return of a portfolio & evaluate the performance of portfolios based on these measures.
Calculate and understand the MONEY WEIGHTED RATE OF RETURN.
Money Weighted Rate of Return= the internal rate of return
- The MWRR is the rate (r) that we solve for when we set:
**SUM OF PV CASH FLOWS = SUM OF INITIAL
INVESTMENT
** LEIGHMANS TERMS- JUST FIND THE IRR USING
CASH FLOW FUNCTION
- You can calculate it manually as well:
- ** sum [cf/ (1+R)^T] = initial future cash flows ***
LOS 7.d) Calculate & compare the money-weighted & time-weighted rates of return of a portfolio & evaluate the performance of portfolios based on these measures.
Calculate and understand the TIME WEIGHTED RATE OF RETURN.
The time weighted rate of return is SPECIFIC FOR AN INVESTOR:
- He takes the Holding Period Return for his stocks and he averages them.
Formula for TWRR (Time Weighted Rate of Return):
** TWRR= [(1+HPR)(1+HPR)/2] - 1 ***
LOS 7.e) Calculate and interpret the bank discount yield, holding period yield, effective annual yield, and money market yield for the US Treasury bills and other money market instruments.
What money instrument are all of these different yields solely applied to?
Applied to SOLELY T-BILLS!
LOS 7.e) Calculate and interpret the bank discount yield, holding period yield, effective annual yield, and money market yield for the US Treasury bills and other money market instruments.
Please explain to me the meaning of a T-bill and how you would calculate/understand the T-bills given rate? How does the T-bill relate to the bank discount yield (BDY)? How do you calculate BDY?
T-bill:
The T-Bill is the government given rate for an investor. A T-bill is given out by banks to investors.
T-bill interest rate= (FACE VALUE- ASKING PRICE)/ (FACE VALUE)
BDY= (T-BILL RATE)* (365/T) T= The amount towards maturity
Bank Discount Yield= a yearly yield for the T-bill even if it matures before 1 year.
THATS WHY A T-BILL IS ALSO CALLED A BANK DISCOUNT YIELD*
LOS 7.e) Calculate and interpret the bank discount yield, holding period yield, effective annual yield, and money market yield for the US Treasury bills and other money market instruments.
Please explain the holding period yield and how to calculate it.
The holding period yield is the same as the holding period return:
EX: T-BILLS Holding Period Yield
You calculate it the same way:
HPY/HPR= (Price Final - Price initial + Dividends)/ (Price initial)
LOS 7.e) Calculate and interpret the bank discount yield, holding period yield, effective annual yield, and money market yield for the US Treasury bills and other money market instruments.
Please explain to me the effective annual yield.
Effective annual yield is the same as effective annual return:
A.) EAY= [1+ (Stated annual yield/n)^(n*m))]-1
B.) EAY= ([1+HPY]^(365/T) - 1)
memorize -> the effective annual yield is also equal to [(1+HPR)^(365/T) -1]
