Week 1- Introduction To Discounting Flashcards
Define shares
Are a unit of ownership of a company
Define Shareholders
Those who own a share in the company
Define Share Price (2)
• The market value of the share as determined by the market itself
• is a function of the sum of expected future dividends
Define dividend
Is the distributed profit given to shareholders (as decided by the board) divided by the number of shares in circulation
Define risk
Is an event which can be described in terms of probability
Define uncertainty
An event which cannot be assigned a probability
Define Investment
An outlay, usually at the start of a scheme, assigned (usually) with the intention of making a (sufficient) return
Define return on investment
The amount returned following the investment; there are various ways of measuring it
Define profit
Profit can be gross or net influenced by non-cash items such as depreciation of assets
Define cash
Is the physical increase or decrease in the volume of money
Define cash flow
Is the increase or decrease of cash over time
Define tax
Is the corporation tax paid to government based on a % of a profit. Tax is a real cash movement
Define depreciation
A “non-cash” allocation made to allow for the “consumption” of an asset, which is deducted from gross profit
What is shareholders wealth and what is the benefit of it increasing?
• Shareholder wealth usually means increasing the share price and paying dividends
• It can be beneficial because it can lead to companies paying more tax, hiring new people and they are paying tax (so increased employment and tax to the state on public services)
Which factors can influence shareholder value? (7)
• Customer Service
• Employee Morale
• Corporate Social responsibility
• Credit rating
• Attitude to risk
• Reputation of the business
• Innovation capability
What does the decision to proceed with an investment require?
It requires the expected outcome/return being greater than the required outcome/return
3 ways of defining the viability of an investment
• Accounting rate of return (ARR)
• Simple payback
• Discounted cash flow (DCF) Analysis
What is the formula for the accounting rate of return (ARR)?
ARR = Average profit (profit before interest and tax across the years of the investment )/initial investment
Define simple payback (2)
• Is another way of measuring whether to proceed with an investment where if cash returned is greater than cash outlay within a defined period then proceed with the investment
• Example: Payback period limit is set at 5 years. Outlay was £20,000 and cash returned each year was £3000. The total cash returned in the payback period would be 5 x £3000 = £15,000 which less than the outlay this the project would not proceed
What is a limitation of simple payback?
Is a very rudimentary (limited/basic) method and is generally used as an initial guide
What is Discounted Cash Flow (DCF) Analysis (2)
• Is where the net present value (NPV) is the SUM of future discounted cash flows
• NPV represents the summated cash of a project or investment expressed in terms of money TODAY
What is the core principle surrounding money? (3)
• Money today is worth more than money tomorrow because it could be invested to achieve a return, or it could be used to avoid borrowing costs, thus saving interest charges
• The investment return or borrowing interest rate avoided is called the discount rate “r” (or i, k)
• Each year the value of a unit of money reduces by r (or i,k) sometimes referred to as the time value of money
What is the formula for discounted present value (DPV)? (4)
• FV = Future value (expected cash income/outlay during any use year)
• I (or r,k) = discount rate
• n = Years into the future
• 1/(1+i)^n = the “discount factor”
What is the formula for discounted present value (DPV)? (4)
• FV = Future value (expected cash income/outlay during any use year)
• I (or r,k) = discount rate
• n = Years into the future
• 1/(1+i)^n = the “discount factor” this is the bottom half of the equation
What is the NPV/DCF formula?
• k (or r) = discount rate
• CF = Cash flow in the year
• CF0 = Initial cash flow (year zero)
• n = number of years
• NPV = Net present value of the project
How’s does NPV impact the viability of a investment
If the NPV is greater than zero than it is worth doing
Tips for answering NPV/DCF Questions
• Remember to add the residual/scrap value in the final year NPV calculation if it’s not sold a year after the project/investment is completed
• Always use the discount factor: 1/1+K^n
Formula for discounted cash flow (DCF Analysis)
Formula for the NPV for an investment that goes over a number of years
Is the sum of the DCF for each year
