Types

of Discounting:

There are different types of discounting with reference to cash flows;

1. Discounting a single sum.
2. Discounting annuity (for constant annual cash flows for a number of years)
3. Discounting Perpetuity

Annuity Discounting – Normal

PV = Annual Cash flow x 1 – (1+i)^-n
i

L
Project A Project B Discounting PV of PV of Project
Year ,000 ,000 @ 10% Project A B
1 25 7 0.909 23 6

D
2 25 7 0.826 21 6
a 25 7 0.751 19 5
4 25 7 0.683 17 5
-S
5 25 7 0.621 16 4
3.791 95 27
PV of Project A 25 x 3.791 95
PV of Project B 7 x 3.791 27
C

Annuity is series of cash flows having Perpetuity is series of cash flows having
following 3 characteristics following 3 characteristics
• Equal cash flows • Equal cash flows
PA

• Occurring at regular intervals & • Occurring at regular intervals &

• For definite / defined period of time • For indefinite / undefined period of time

Series of cash flows having all
Annuity above mentioned 3 characteristic Present Value calculation =
and starting
Normal Annuity After 1 year from today R x 1 – (1+i)^-n
i
Advanced Annuity Immediately R + R x 1 – (1+i)^-n+1
I
Delayed Annuity Beyond 1 (2, 3 or onward) year 1. Apply normal annuity formula
from today at one period earlier than first
payment
2. Now again discount this PV to
To using single discounting
formula.

 Calculate Present Value of annuity of Rs1,000/- pa starting;
(Cost of capital is 10%)
a) 1 year from now
b) Immediately
c) in 3 Years from now
Normal Annity
0 1 2 3 4 5




1,000 1,000 1,000 1,000 1,000

L
PV = Annual Cash flows x annuity factor

D
PV = 1,000 X 3.791 3,791

Advanced Annuity
-S
0 1 2 3 4 5


1,000 1,000

1,000 1,000 1,000

C

3,170 1,000 x 3.17

PA

1,000
PV = 4,170

Delayed Annuity
0 1 2 3 4 5 6 7

1,000 1,000 1,000 1,000 1,000

3,791 1,000 x 3.791

x
PV = 3,132.88 0.826

 Series of cash flows having all Cannot calculate PV step by
Perpetuity above mentioned 3 stop as its payments are
characteristic and starting forever. So PV calculation =
Normal Perpetuity After 1 year from today ___R .
i
Advanced Perpetuity Immediately R + __R___
I
Delayed Perpetuity Beyond 1 (2, 3 or onward) 1. Apply normal perpetuity
year from today formula at one period
earlier than first payment
2. Now again discount this
PV to To using single

L
discounting formula.
Calulate Present Value of perpetuity of Rs1,000/- pa starting;
a) 1 year from now

D
b) Immediately
c) in 3 Years from now
cost of capital is 10% pa
-S
Normal Perpetuity
0 1 2 3 4

1,000 1,000 1,000 1,000 onward
PV = 1,000 / 0.10 10,000
C
Advanced Perpetuity
0 1 2 3 4
onward
PA

1,000 1,000 1,000

1,000 1,000

1,000 / 0.10
10,000
1,000
PV = 11,000
Delayed Perpetuity
0 1 2 3 4
onward
1,000 1,000

10,000 1,000 / 0.10

x
PV = 8,264 0.826
Internal Rate of Return (IRR)

IF NPV is Positive we conclude: Project rate of return > Cost of capital (discount rate)
IF NPV is Negative we conclude: Project rate of return < Cost of capital (discount rate)
What if NPV = 0, what shall we conclude?

“A zero NPV means that the investment earns a rate of return equal to the discount rate. If you
discount the cash flows using a 6% real rate and produce a Rs.0 NPV, then the analysis indicates
your investment would earn a 6% real rate of return.”

Although if NPV is positive the our wealth increases, however at 0 NPV at least our all project
related expenses are adjustment then we may accept the project even at 0 NPV.

L

Now the question is what is the rate at which our NPV will become 0?
• IRR is the rate at which NPV of the project’s cash flows will become 0.

D
• It can be calculated by hit and trial method
• By testing different rates and
• Identifying a rate where NPV = 0.
-S

But in exam we don’t have time so we can calculate it with following steps.
1. Estimate cash flows of the project (initial investment and future benefits)
2. Select any two discount rates
3. Calculate two NPVs with these two rates.
C
4. Use following interpolation formula to estimate IRR

IRR = L + [ ___NL x (H –L)]
PA

NL-NH
L = lower discount rate
H = higher discount rate
NL = NPV with lower rate
NH = NPV with higher rate

Conclusion: if IRR > Co. Rate of Return = Accept the Project
if IRR < Co. Rate of Return = Reject the Project
Year (a) Discounting @ 15% Present Value Discounting @ 20% Present Value
0 (90) 1.000 (90) 1.000 (90)
1 40 0.870 35 0.833 33
2 30 0.756 23 0.694 21
3 20 0.658 13 0.579 12
4 20 0.572 11 0.482 10
5 24 0.497 12 0.402 10
4 (5)
Using interpolation formula
15% + 4 x 5.00%
9
15% + 2% = 17.23%

Year (a) 17% PV
0 (90) 1.000 (90)
1 40 0.853 34
2 30 0.728 22
3 20 0.621 12
4 20 0.530 11

L
5 24 0.452 11
(0)

D
Advantages:
1. Consider time value of money
2. Based on cash flows
-S
3. Consider whole life of the project
4. Percentage terms; easy to understand
5. Cost of capital is not required to be known for its calculation


C
Disadvantages:
1. Not absolute measure
2. Interpolation just provides estimates
3. Complicated to calculate
PA

4. Non-conventional cash flows may give rise to multiple IRRs

5. At time conflicting with NPV

If there is a conflict between NPV and IRR,

• NPV will be preferred for project investment as re-investment assumption of NPV is more
realistic.
• More over NPV is also in line with financial management’s objective (maximization of
shareholder’s wealth).
• Projects with same return of IRR is far more difficult as compared to project giving return
equal to cost of capital. (will discuss in detail later)