week 5 Flashcards
explain the basic dcf concept
The value of an investment asset can be measured by all of its cash flows generated during the holding period.
Example:
An investment asset generates two cash flows only: 1 million in year one and -1.2 million in year ten. Is the value of this asset negative?
A:positive
B:negative
C:can not be determined based on the information given
Can’t compare due to the different time values of money
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define time value of money
To counter this ‘time travel’ can be undertaken bringing all the cash flows to the same period of time
You deposit $1,000 in an interest-bearing account at a local bank. The account pays 3% interest compounded annually, and you expect to withdraw the original principal, plus accumulated interest, at the end of 2 years.
How much will be in your account after 2 years?
Fv = (1+i)^n X PV
(1+0.3)^2 X $1000
= 1069.90
You deposited certain amount of money in an interest-bearing account at a local bank 3 years ago. The account pays 3% interest compounded annually, and the current balance is $5,463.64. How much money did you deposit in this account 3 years ago?
Pv = FV/(1+i)^n
=5,463.63/(1+0.3)^3
=5,000.13
explain DCF process
o Before we can compare and put cash flows from different years in one calculation, we need to convert them to their equivalent values in one same single year
o Convert to one future year-compound - FV= (1+i)n x PV;
o Convert to one previous year-discount - PV= FV/ (1+i)n
o It is easiest to convert all projected cash flows to their “PV” - beginning of the holding period, thus Discounted Cash Flow (DCF)
The process of discounting: converting all the cash flows in different years into their PV at the end of year 0 (beginning of year1)
An investment asset generates two cash flows only: 1 million in year one and -1.2 million in year ten. Is the current value of this asset negative if the discount rate is 5%?
Value= PV1+PV10
= CF1/((1+i)^1)+CF10/((1+i)^10)
=1/((1+5%)^1 (-1.2)/((1+5%)^10)
=0.26
explain DCF role in real estate
Assumed that the value (market value / investment value) of an investment grade property is reflected by its income producing capacity
Value of an investment grade property quals to the sume of the present value of all cash flows (both in and out) generated by the investment grade property
Cash flows need to consider: NOI and expected reselling price
Cash flow needs to consider NOi and expected reselling price
Step 1: Determine the discount rate
Step 2: Projecting property relevant cash flows
• Net operating income (NOI) during the holding period
• Expected Reselling Price : cash inflow by selling the property at the end of the holding period
Step 3: Discount and add up the projected NOI and Expected Reselling Price to work out the value of the property
• The rate that is used to convert the cash flows: calculate the amount (PV) of cash flows that happen at different point of time but are equivalent
- In DCF for valuation, used to calculate the PV of all the cash flows
- Could be interest rate, expected rate of return, required rate of return……
- Correctly estimation of discount rate is crucial for DCF valuation model
Different types of rates used to discount cash flows:
Expected rate of return (market value) is the amount one would anticipate receiving on an investment that has various known or expected rates of return. The general level of return of similar asset on the market.
-Market extracted method- comparables actual return (IRR-internal rate of return)
-Capital Asset Pricing Model (CAPM)
Expected rate of return is used to calculate the Market value, derived from the market
Required rate of return by investor (investment value)- Required Rate of Return in Corporate Finance, ‘Weighted Average Cost Of Capital – WACC
DCF in real estate (week 6)
o DCF model- Firstly, discount all the cash inflows and cash outflows back to the beginning (PV). Then we can compare and add them up
Assumes that the value (market / investment value) of an investment grade property is reflected (measured) by it’s income producing cacity
o Can not value heritage buildings e.g. as they were not built with the intenton of being an income producing asset for the investor unlike a “investment grade property”
o Value of an investment grade property equals to the sum of the present value of all the cash flow (both in and out) generated by the investment grade property
o However can not all be added up together due to the varying time value of money existing
o Cash flows that need to be considered: NOI and Expected reselling price (only consider property related factors, reflect income of property
define equity
The amount of capital that belongs to the investor, (value of property usually equal or higher than equity)
explain investment feasibility
o Total of cash inflows to the equity > total of cash outflow from the equity = Good (Equity of the investor has increased)
o Total cash inflows to the equity < total of cash outflows from the equity = Bad
o Not all the cash flows generated by the property (NOI and expected reselling price) can flow into the equity. Cash outflow from the equity in the beginning to purchase the property (initial outlay)
o Cash flows need to consider: Initial Outlay, After Tax CF’s from operation and resale proceeds after tax
How is initial outlay calculated
The money invested by the investor from the equity when acquiring an investment grade property
purchase price of property (+) costs of acquisition (+) any additional repairs or improvements required to make the property leasable (-) amount borrowed = initial outlay
calculating after tax cash flow from operations
normal NOI calculations then (-) debt service (interest) (-) taxes from operation = after tax cash flow from operations
DCF formula fro depriving NPV
see notes
NPV = Total PV of all cash inflows – Total PV of all cash outflows (Including CF0:initial outlay)
NPV is an indicator of how much value the investment adds to the value of the investor’s Equity
The investor’s Equity will increase by the positive NPV
NPV=Total PV of All Cash Inflows – Total PV of All Cash Outflows (Including CF0)
- In property investment analysis, the CF0 is the Initial Outlay, CF1 to CFn include all the after tax CFs from operation and Resale proceeds after tax.
- All the CFs could be inflow or outflow
