Ss 2. R 6. Discounted Cash Flow Applicatiopns

Front 1

Definition of NPV

Back 1

SUM OF the present values (PV's) of ALL EXPECTED INCREMENTAL CASH INFLOWS generated by the project undertaken MINUS SUM OF the present values (PV's) the ALL EXPECTED CASH OUTFLOWS of the project undertaken

Front 2

Definition of Present Value of Cash Flow

Back 2

PV of Project's Cash Flow is a value of the future Cash Flow DISCOUNTED to a given point in time AT a DISCOUNT RATE that is NOT LESS THAN the firm's COST OF CAPITAL

Front 3

NPV calculus

Back 3

1. Identify ALL CIFs and COFs 2. Determine the appropriate DISCOUNT RATE or OPPORTUNITY COST (r) 3. Find the PV of each cash flow 4. Sum ALL PVs 5. Apply the NPV rule

Front 4

NPV Rule for Independent investments

Back 4

ACCEPT investments IF NPV > 0; REJECT investments IF NPV < 0

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NPV rule for Mutually Exclusive Investments

Back 5

ACCEPT an investment with HIGHER POSITIVE NPV

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NPV advantages

Back 6

1. Measures an INCREASE in a VALUE of the firm 2. Assumes REINVESTMENT at a DISCOUNT RATE (OPPORTUNITY COST of CAPITAL) 3. Based on Time Value of Money

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NPV limitations

Back 7

does NOT include any consideration of the size of the project

Front 8

Definition of IRR

Back 8

1. a DISCOUNT RATE that makes NET PRESENT VALUE = 0; 2. SUM OF the PRESENT VALUES (PV's) of ALL EXPECTED INCREMENTAL CASH INFLOWS generated by the project undertaken IS EQUAL to SUM OF the PRESENT VALUES (PV's) the ALL EXPECTED CASH OUTFLOWS of the project undertaken

Front 9

IRR Rule for Independent investments

Back 9

ACCEPT investments IF IRR > OPPORTUNITY COST of CAPITAL(hurdle rate); REJECT investments IF IRR < OPPORTUNITY COST of CAPITAL(hurdle rate)

Front 10

IRR Rule for Mutually Exclusive Investments

Back 10

IF (Project A's IRR > Project B's IRR AND Project A's IRR > OPPORTUNITY COST of CAPITAL) THEN ACCEPT Project A

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Dependence of NPV upon IRR

Back 11

1. IF (IRR > OPPORTUNITY COSTof CAPITAL) THEN NPV > 0; 2. IF (IRR < OPPORTUNITY COST of CAPITAL) THEN NPV < 0 ; 3. IF (IRR = OPPORTUNITY COST of CAPITAL) THEN NPV = 0

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IRR advantages

Back 12

1. Considers Time Value of Money; 2. Considers ALL CASH FLOWS

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IRR limitations

Back 13

1. assumes REINVESTMENTat the IRR; however, this MAY NOT always BE REALISTIC; 2. there may be MULTIPLE or NO IRR in case of NONCONVENTIONAL CASH FLOW PATTERN; 3. expressed in PERCENTAGE terms; this involves DIFFICULTIES in RANKING projects

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IRR rule vs NPV rule characteristics

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1. SAME investment RANKING for INDEPENDENT projects; 2. DIFFERENT investment RANKING when the PROJECTS are DIFFERENT in SIZEof cash flows and when the PROJECTS are DIFFERENT in TIMINGcash flows; 3. NPV preference for MUTUALLY EXCLUSIVE projects

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Holding Period Return

Back 15

Percentage increase in wealth over a period

Front 16

Definition of Money-Weighted Rate of Return

Back 16

IRR on a portfolio that takes into  account all cash  inflows  and outflows

Front 17

Definition of Cash InFlows in MWRR

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1. BEGINING VALUEof the account; 2. The PROCEEDSfrom any INVSTMNT SOLD; 3. DIVIDENDS/INTRST RECEIVED; 4. CONTRIBUTIONS

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Definition of Cash OutFlows in MWRR

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1. COST of INVSTMNT PURCHASED; 2. DIVIDENDS/INTRST REINVESTED; 3. WITHDRAWALS; 4. ENDING VALUE of the account

Front 19

MVRR calculus

Back 19

1. Determine each CASH FLOW as Cash InFlow or Cash OutFlow; 2. Determine the TIMING of each CASH FLOW; 3. Net the CASH FLOWS FOR each TIME PERIOD; 4. Set the Present Value of Cash InFlows EQUAL TO Present Value of Cash OutFlows; 5. Solve for IRR

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MVRR characteristics

Back 20

1. Applies IRR calculus; Sensetive to the TIMING and AMOUNT of CASH INFLOWS and OUTFLOWS

Front 21

Definition of TWRR

Back 21

1. Measures compound growth; 2. Rate at which $1 compounds  over  a  specified  performance horizon; 3. Result value of the  process of averaging a set of  values  over time

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TWRR calculus

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1.FORM SUBPERIODS over the evaluation period that correspond to the dates of deposits and withdrawals
2. EVALUATE PORTFOLIO VALUE at the dates of deposits and withdrawals
3. COMPUTE HPR for each subperiod
4. COMPUTE the PRODUCT of (1+HPR) for each subperiod
5. IF the TOTAL INVSTMNT PERIOD is GREATER than ONE YEAR then TAKE the GEOMETRIC MEAN of the measurement period return

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TWRR advantages

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1. PREFERRED method of performance measurement
2. NOT AFFECTED by the TIMING of CASH INFLOWS and CASH OUTFLOWS
3. PROVIDES a better measurement of a manager's ability to select investments over the period

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MVRR vs TVRR characteristics

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1. Funds contributed just before a period of relatively poor portfolio performance result in MVRR < TWRR
2. Funds contributed just prior a period of relatively high portfolio performance result in MVRR > TWRR
3. In Case of COMPLETE CONTROL over money FLOWS result in MVRR is more appropriate performance measurement

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Drawbacks of Bank Discount Yield

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1. is BASED on the FACE VALUE RATHER THAN PURCHASE PRICE (NOT TRUE rate of return)
2. is ANNUALIZED on a 360-DAY YEAR RATHER THAN a 365-DAY YEAR (SHORT year)
3. ANNUALIZES with SIMPLE INTEREST (WITHOUT COMPOUNDING)

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Definition of Holding Period Yield

Back 26

1. Determines RETURN EARNED by HOLDING the instrmnt TO MATURITY
2. Refers to an UNANNUALIZED RATE of RETURN (being PERIODIC RATEof RETURN)
3. Applies to instrmnts that make ONE CASH PAYMENT DURING ITS LIFE
4. May be applied to an INTEREST BEARING INSTRUMENT