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LECTURE 06

DISCOUNTEDCASHFLOWAPPLICATIONS
INSTRUCTOR SLIDES
QUANTITATIVEMETHODS
Net Present Value
The net present value (NPV) of an investment equals the present value of all expected
inflows from the investment minus the present value of all expected outflows.
The rate used to discount the cash flows is the appropriate cost of capital, which
o Reflects the opportunity cost of undertaking the particular investment
o Compensates investors for various risks inherent in the investment
o Assumes that all cash flows from the project will be reinvested at the cost of capital.
Calculation
1. Identify all cash inflows and outflows associated with the investment.
2. Determine the appropriate discount rate.
3. Compute the PV of all cash flows.
4. Aggregate all the present values, with inflows as positive values, and outflows as
negative values.
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t 1 2
0
1 1 t
CF CF CF
NPV =CF + + +.... +
1 +r 1 +r 1 +r
Net Present Value
The NPV Rule
1. Positive NPV projects increase shareholder wealth and should be accepted.
2. Negative NPV projects decrease shareholder wealth and should be rejected.
3. For mutually exclusive projects the project with the highest, positive NPV should be
chosen as it would add the most value to the firm.
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Net Present Value
Example: Applying the NPV Rule
ABC Corporation is preparing a feasibility study for a project that has an initial cost of $8
million. It will generate no cash flows in the first year. However, the project will generate
positive cash flows of $2 million at the end of the second year, $3.2 million at the end of
third year and $3.3 million at the end of fourth year. Assume that the discount rate is 12%.
Calculate the NPV of the project and determine whether the company should invest in it.
Solution
NPV =-$8 +$0 +$1.594 +$2.277 +$2.097
NPV =-$2.030706 million
The company should NOT pursue the project because it has a negative NPV.
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2 3 4
$2 $3.2 $3.33
NPV = $8 +$0 + + +
1.12 1.12 1.12

Internal Rate of Return


The internal rate of return (IRR) of a project is the discount rate that equates the projects
NPV to zero.
It is the discount rate that equates the present value of all inflows from a project to the
present value of all project-related outflows.
o It assumes that all cash flows from the project will be reinvested at the IRR.
The IRR Rule
IRR >required rate of return =Project Accepted
IRR <required rate of return =Project Rejected
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Internal Rate of Return
Example: Computing IRR
Calculate the IRR of an investment project with an initial cost of $10 million. This project
generates positive cash flows of $3 million at the end of Year 1, $4.8 million at the end of
Year 2 and $5.5 million at the end of Year 3.
Solution
Solving this equation through trial and error provides
an IRR of 14.2%.
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1 2 3
$3 $4.8 $5.5
0 = $10 + + +
1 +IRR 1 +IRR 1 +IRR

Internal Rate of Return


In deciding whether a single project should be undertaken, IRR and NPV will offer the same
recommendation.
If IRR >required rate of return =NPV is positive.
If IRR <required rate of return =NPV is negative.
Problems associated with the IRR
For mutually exclusive projects, NPV and IRR may offer conflicting conclusions when:
the projects initial cash outlays are different.
there is a difference in the timing of cash flows across the projects.
When choosing between mutually exclusive projects, use the NPV rule if the
recommendations of the NPV and IRR rules conflict.
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Internal Rate of Return
Example: When the timings of Cash Flows is different
Solution
The NPV rule recommends that the company should choose Project C
IRR rule suggests that Project B should be undertaken
When the two are in conflict, the NPV rule is given preference.
Therefore, the company should invest in Project C as it adds more to company value.
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Additional Problems with IRR
Multiple IRR problem: Projects with a nonconventional cash flow pattern may have more
than one IRR. There maybe two discount rates that will produce an NPV of zero.
No IRR problem: It is also possible to have a positive NPV project with no IRR meaning
that there is no discount rate that results in a zero NPV.
Note:
These additional problems of IRR are discussed in detail in Corporate Finance.
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Holding Period Return
HPY is quite simply the return earned on an investment over the entire investment horizon.
For example, if an investor purchases a share of stock for $100, receives a dividend of $5,
and sells the stock for $110 in 9 months, her HPY on the investment is calculated as:
Example: Stock purchased one year ago for $29 just paid a dividend of $1.30 and is valued
at $30.50.
1-year HPR is
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(30.50 +1.30) / 29 1 =9.66%
Money-Weighted Rate of Return
The money-weighted rate of return is simply the IRR of an investment. It accounts for the
timing and amount of all dollar flows into and out of the portfolio.
Example: Money-Weighted Rate of Return
An investor purchases a share for $50 today. At the end of the year, she purchases another
share for $60. At the end of Year 2, she sells both shares for $65 each. At the end of each
year during the holding period, she also receives a dividend of $1 per share. What is her
money weighted rate of return on the investment?
Step 1: Determine the timing and nature of the cash flow.
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Inflows are positive cash flows
Outflows are negative cash flows
Money-Weighted Rate of Return
Solution (Contd.)
Step 2: Equate the PV of cash outflows to the PV of cash inflows:
PV of outflows = PV of inflows
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Step 3: Calculate the value of r to find the
money weighted return using Trial and error
and using IRR function on Financial Calculator.
1 2
59 132
50 + =
(1 +r) (1 +r)
Time-Weighted Rate of Return
Thetime weighted rate of return measures the compounded rate of growth of an investment
over a stated measurement period. In contrast to money-weighted return, the time-weighted
return:
1. Is not affected by cash withdrawals or contributions to the portfolio.
2. Averages the holding period returns over time.
The standard in the investment management industry is to express returns on a time-
weighted basis.
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Time-Weighted Rate of Return
Example: Time-Weighted Return
An investor purchases a share for $50 today. At the end of the year, she purchases another
share for $60. At the end of Year 2, she sells the shares for $65 each. At the end of each year
in the holding period, she also receives $1 per share as dividend. What is her time-weighted
rate of return?
Solution
Step 1: Break down the cash flows into 2 holding periods based on the their timing:
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Time-Weighted Rate of Return
Solution (Contd.)
Step 2: Calculate the HPY for each period.
HPY
1
=[(60 +1)/50] - 1 =22%
HPY
2
=[130 +2)/120] - 1 =10%
Step 3: Finally, calculate the compounded annual rate that would produce the same return as
the investment over the two-year period.
(1 +time-weighted rate of return)
2
=(1 +HPY
1
)(1 +HPY
2
) =(1.22)(1.10)
Time weighted rate of return =[(1.22) (1.10)]
0.5
1 =15.84%
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Time-Weighted Rate of Return
Important Takeaways
Time-weighted rate Not affected by the timing and amount of cash inflows and
outflows. (Preferred Method)
Discretion of portfolio
manager over withdrawals
and contributions
Funds are deposited into the
investment portfolio
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Use money-weighted returns
Yes
No
Use time-weighted returns
Money-weighted return
will be higher than
time-weighted return
prior to a period of
superior performance
just before a period of
relatively poor performance
Money weighted return
will be lower than
time-weighted return
Market Yields Bank Discount Yield (BDY)
BDY is used primarily for quoting Treasury bills. It is computed as:
Bank discount basis do not hold much meaning to investors for the following reasons:
1. BDY calculates returns based on par.
2. Returns are based on a 360-day year rather than a 365-day year.
3. BDY assumes simple interest.
Example: Calculate the bank discount yield for a T-bill with a face value of $1,000 that is
currently priced at $960 and has 240 days remaining till maturity.
Solution
D =$1,000 - $960 =$40; F =$1,000; t =240
Bank discount yield =(D/F) (360/t)
Bank discount yield =(40/1,000) (360/240) =6%
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BD
Discount 360
r =
Face Value t

Market Yields Holding Period Yield (HPY)


HPY equals the return realized on an investment over the entire horizon that it is held (which
can either be till maturity or sale).
It is an unannualizedreturn measure.
Example: Calculate the holding period yield on a T-bill with a face value of $1,000 that is
currently trading for $960 and has 240 days remaining till maturity.
Solution
In this example, D
1
is zero as T-bills make no interest payments.
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1 0 1 1 1
0 0
P - P +D P +D
HPY = 1
P P

Market Yields -Effective Annual Yield (EAY)
EAY is an annualized return measure that accounts for compounding over 365-day period. It
is calculated as follows:
Example: Calculating the Effective Annual Yield
Compute the EAY when the HPY of a T-bill is 2.3% and there are 240 days remaining till
maturity.
Solution
EAY=(1 +HPY)
365/t
- 1
EAY =(1 +0.023)
365/240
- 1 =3.52%
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Market Yields -Effective Annual Yield (EAY)
We can also convert an EAY to HPY using the following formula:
Example: Calculating HPY from EAY
Compute the HPY of a T-bill when its EAY is 1.8% and there are 240 days left to maturity.
Solution
HPY =(1 +0.018)
240/365
- 1 =1.18%
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Market Yields -Money Market Yield (MMY)
The money market yield (R
MM
) is the holding period yield annualized on a 360-day basis.
It does not consider the effects of compounding.
It is different from the bank discount yield as it is based on the purchase price, not par
value.
For Treasuries, the money-market yield can be obtained from the bank discount yield
using the following formula.
And more conveniently:
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Market Yields -Money Market Yield (MMY)
Example: Money Market Yield
What is the money market yield for a T-bill that has 90 days to maturity if it is selling for
$99,500 and has a face value of $100,000?
Solution
The simpler way is to use the second formula and calculate the HPY to compute the money
market yield.
R
MM
=HPY (360/t)
R
MM
=0.5025% (360/90) =2.01%
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Market Yields -Money Market Yield (MMY)
Example: Money Market Yield
What is the money market yield for a 240 day T-bill that has a bank discount yield of 5%?
Solution
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Yield Example: 90-day T-bill Priced at $980
90-day HPY
Simple
annualized
discount
Effective rate
Simple annualized
365
90
20 360
BDY = =8%
1,000 90
1,000
HPY = 1 =2.04%
980
EAY =(1 .0204) 1 =8.53%
360
MMY =0.0204 =8.16%
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Market Yields -Bond Equivalent Yield (BEY)


BEY is simply the semiannual discount rate multiplied by two.
This convention comes from the U.S.
Example: A 3-month loan has a holding period yield of 3%. What is the yield on a bond
equivalent basis?
Solution
Step 1: Semiannual yield =(1 +3-month yield)
2
- 1 =(1.03)
2
- 1 =6.09%
Step 2: BEY =2 6.09% =12.18%
Example: The EAY (effective annual yield) on an investment is 7%. What is the yield on a
bond-equivalent basis?
Solution
Step 1: Semiannual yield =( 1 +EAY )
0.5
- 1 = 1.07
0.5
-1 =3.44%
Step 2: BEY =Semiannual yield 2 =3.44% 2 =6.88%
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