Unit 3

CASH FLOW

● Cash flow refers to the net balance of cash moving into and out of a business at a specific point in time.

● Cash is constantly moving into and out of a business. For example, when a retailer purchases inventory, money
flows out of the business toward its suppliers. When that same retailer sells something from its inventory, cash
flows into the business from its customers. Paying workers or utility bills represents cash flowing out of the
business toward its debtors. While collecting a monthly instalment on a customer purchase financed 18
months ago shows cash flowing into the business. The list goes on.
● Cash flow can be positive or negative. Positive cash flow means a company has more money moving into it
than out of it. Negative cash flow indicates a company has more money moving out of it than into it.
Types of Cash Flow
● Operating cash flow: This refers to the net cash generated from a company’s normal business operations. In
actively growing and expanding companies, positive cash flow is required to maintain business growth.
● Investing cash flow: This refers to the net cash generated from a company’s investment-related activities, such
as investments in securities, the purchase of physical assets like equipment or property, or the sale of assets.
In healthy companies that are actively investing in their businesses, this number will often be in the negative.
● Financing cash flow: This refers specifically to how cash moves between a company and its investors, owners,
or creditors. It’s the net cash generated to finance the company and may include debt, equity, and dividend
payments.

Time Value of Money (TVM)

The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will
be at a future date due to its earnings potential in the interim. The time value of money is a core principle of
finance. A sum of money in the hand has greater value than the same sum to be paid in the future. The time
value of money is also referred to as the present discounted value.
Understanding the Time Value of Money (TVM)
● Investors prefer to receive money today rather than the same amount of money in the future because a sum
of money, once invested, grows over time. For example, money deposited into a savings account earns
interest. Over time, the interest is added to the principal, earning more interest. That's the power of
compounding interest.
● If it is not invested, the value of the money erodes over time. If you hide $1,000 in a mattress for three years,
you will lose the additional money it could have earned over that time if invested. It will have even less buying
power when you retrieve it because inflation reduces its value.
● As another example, say you have the option of receiving $10,000 now or $10,000 two years from now.
Despite the equal face value, $10,000 today has more value and utility than it will two years from now due to
the opportunity costs associated with the delay. In other words, a delayed payment is a missed opportunity.
● The time value of money has a negative relationship with inflation. Remember that inflation is an increase in
the prices of goods and services. As such, the value of a single dollar goes down when prices rise, which means
you can't purchase as much as you were able to in the past.
Time Value of Money Formula
● The most fundamental formula for the time value of money takes into account the following: the future
value of money, the present value of money, the interest rate, the number of compounding periods per year,
and the number of years.
● Based on these variables, the formula for TVM is:

Components of TVM
The key components are as mentioned below –
1. Interest/Discount Rate (i)– It’s the rate of discounting or compounding that we apply to an amount of
money to calculate its present or future value.
2. Time Periods (n) – It refers to the whole number of time periods for which we want to calculate the present
or future value of a sum. These time periods can be annually, semi-annually, quarterly, monthly, weekly, etc.
 3. Present value (PV)– The amount of money that we obtain by applying a discounting rate on the future value
of any cash flow.
4. Future value (FV)– The amount of money that we obtain by applying a compounding rate on the present
value of any cash flow.
5. Installments (PMT)– Installments represent payments to be paid periodically or received during each
period. The value is positive when payments have been received and become negative when payments are
made.

Present Value (PV)

● The present value is known as the current value of a sum of money that we will receive in the future.

● We have mentioned that the purchasing power of money reduces over time. The formula of PV accounts for
this reduction by applying a discounting rate to the sum that we will receive in the future.
● Due to the use of the discounting rate, the process of calculating the present value of a sum of money is also
known as discounting a sum of money.
● The PV of a sum of money can be used to determine the current value of projected cash flow from a bond, an
annuity, a loan, or any such instance where you are supposed to receive money from a third party in the future
and you want to know exactly how much that money will be worth today.
● It is given by the following formula –
PV = FV / (1 + i)^n
Here, we require three things to calculate the present value –
1. What is the value of the sum we will receive in the future? (FV);
2. What is the rate of discounting at which the purchasing power of the money will fall? (i); and
3. After how many years will we receive the concerned sum of money? (n).

Future Value (FV)

As the name goes, the FV denotes the value of a sum of money at some date in the future.
This calculation is useful for investors and businesses who want to know the future value of their potential
investments to make a good investment decision.
The formula for FV is given by –
FV = PV (1+i)^n

Perpetuity

Perpetuity in the financial system is a situation where a stream of cash flow payments continues indefinitely or
is an annuity that has no end. In valuation analysis, perpetuities are used to find the present value of a
company’s future projected cash flow stream and the company’s terminal value. Essentially, perpetuity is a
series of cash flows that keep paying out forever.
 Finite Present Value of Perpetuity
Although the total value of a perpetuity is infinite, it comes with a limited present value. The present value of
an infinite stream of cash flow is calculated by adding up the discounted values of each annuity and the
decrease of the discounted annuity value in each period until it reaches close to zero.
An analyst uses the finite present value of perpetuity to determine the exact value of a company if it continues
to perform at the same rate.
Real-life Examples
Although perpetuity is somewhat theoretical (can anything really last forever?), classic examples include
businesses, real estate, and certain types of bonds.
One example of a perpetuity is the UK’s government bond known as a Consol. Bondholders will receive annual
fixed coupons (interest payments) as long as they hold the amount and the government does not discontinue
the Consol.
The second example is in the real-estate sector when an owner purchases a property and then rents it out. The
owner is entitled to an infinite stream of cash flow from the renter as long as the property continues to exist
(assuming the renter continues to rent).
Another real-life example is preferred stock, where the perpetuity calculation assumes the company will
continue to exist indefinitely in the market and keep paying dividends.
Present Value of Perpetuity Formula
Here is the formula:
PV = C / R
Where:
● PV = Present value

● C = Amount of continuous cash payment

● r = Interest rate or yield

Example – Calculate the PV of a Constant Perpetuity
1. Company “Rich” pays $2 in dividends annually and estimates that they will pay the dividends indefinitely. How
much are investors willing to pay for the dividend with a required rate of return of 5%?
PV = 2/5% = $40.
An investor will consider investing in the company if the stock price is $40 or less.

0. Stock pays a constant dividend of $8 at the end of each year for 20 years at a 25% required rate of
return. Calculate the present value of the stock dividends.
Solution
The constant dividends of the stock are valued as perpetuity. So from the question,
A=8
r=25%

So that:
PV=Ar=80.25=$32

(Perpetuity and annuity problems)

 Perpetuity with Growth Formula
Formula:
PV = C / (r – g)
Where:
● PV = Present value

● C = Amount of continuous cash payment

● r = Interest rate or yield

● g = Growth Rate

Annuity
● An annuity is a financial product that provides certain cash flows at equal time intervals. Annuities are created
by financial institutions, primarily life insurance companies, to provide regular income to a client.
● An annuity is a reasonable alternative to some other investments as a source of income since it provides
guaranteed income to an individual. However, annuities are less liquid than investments in securities because
the initially deposited lump sum cannot be withdrawn without penalties.
● Upon the issuance of an annuity, an individual pays a lump sum to the issuer of the annuity (financial
institution). Then, the issuer holds the amount for a certain period (called an accumulation period). After the
accumulation period, the issuer must make fixed payments to the individual according to predetermined time
intervals.
● Annuities are primarily bought by individuals who want to receive stable retirement income.

Types of Annuities
There are several types of annuities that are classified according to frequency and types of payments. For
example, the cash flows of annuities can be paid at different time intervals. The payments can be made
weekly, biweekly, or monthly. The primary types of annuities are:
1. Fixed annuities
Annuities that provide fixed payments. The payments are guaranteed, but the rate of return is usually minimal.
2. Variable annuities
Annuities that allow an individual to choose a selection of investments that will pay an income based on the
performance of the selected investments. Variable annuities do not guarantee the amount of income, but the
rate of return is generally higher relative to fixed annuities.
3. Life annuities
 Life annuities provide fixed payments to their holders until his/her death.

4. Perpetuity
An annuity that provides perpetual cash flows with no end date. Examples of financial instruments that grant
perpetual cash flows to its holder are extremely rare.
The most notable example is a UK Government bond called consol. The first consols were issued in the middle
of the 18 century. The bonds did not specify an explicit end date and were redeemable at the option of the
th

Parliament. However, the UK Government redeemed all consols in 2015.

Valuation of Annuities
Annuities are valued by discounting the future cash flows of the annuities and finding the present value of the
cash flows. The general formula for annuity valuation is:

Where:
● PV = Present value of the annuity

● P = Fixed payment

● r = Interest rate

● n = Total number of periods of annuity payments

The valuation of perpetuity is different because it does not include a specified end date. Therefore, the value
of the perpetuity is found using the following formula:
PV = P / r

Payback Period:-
The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply
put, it is the length of time an investment reaches a break even point.
People and corporations mainly invest their money to get paid back, which is why the payback period is so
important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining
the payback period is useful for anyone and can be done by dividing the initial investment by the average cash
flows.
KEY TAKEAWAYS

● The payback period is the length of time it takes to recover the cost of an investment or the length of
time an investor needs to reach a breakeven point.
● Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.

● The payback period is calculated by dividing the amount of the investment by the annual cash flow.

● Account and fund managers use the payback period to determine whether to go through with an
investment.
● One of the downsides of the payback period is that it disregards the time value of money.
You can figure out the payback period by using the following formula:
Payback Period=Cost of InvestmentAverage Annual Cash FlowPayback Period
/Average Annual Cash FlowCost of Investment
Example 1:
An investment of $200,000 is expected to generate the following cash inflows in six years:
Year 1: $70,000
Year 2: $60,000
Year 3: $55,000
Year 4: $40,000
Year 5: $30,000
Year 6: $25,000
Required: Compute payback period of the investment. Should the investment be made if management wants
to recover the initial investment in 3 years or less?
Solution:
(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback
period. We can compute the payback period by computing the cumulative net cash flow as follows:

Payback period=3+(15,000*/40,000)
=3+0.375
= 3.375 Years
*Unrecovered investment at start of 4th year:
=Initial cost–Cumulative cash inflow at the end of 3rd year
=$200,000–$185,000
= $15,000
The payback period for this project is 3.375 years which is longer than the maximum desired payback period of
the management (3 years). The investment in this project is therefore not desirable.

NPV (Net Present Value)

The NPV formula is a way of calculating the Net Present Value (NPV) of a series of cash flows based on a
specified discount rate. The NPV formula can be very useful for financial analysis and financial modeling when
determining the value of an investment (a company, a project, a cost-saving initiative, etc.).
Below is an illustration of the NPV formula for a single cash flow.

Screenshot of CFI’s Corporate Finance 101 Course.

NPV for a Series of Cash Flows
In most cases, a financial analyst needs to calculate the net present value of a series of cash flows, not just one
individual cash flow. The formula works in the same way, however, each cash flow has to be discounted
individually, and then all of them are added together.
Here is an illustration of a series of cash flows being discounted:
 Pros
● Considers the time value of money

● Incorporates discounted cash flow using a company’s cost of capital

● Returns a single dollar value that is relatively easy to interpret

● May be easy to calculate when leveraging spreadsheets or financial calculators

Cons
● Relies heavily on inputs, estimates, and long-term projections

● Doesn’t consider project size or return on investment (ROI)

● May be hard to calculate manually, especially for projects with many years of cash flow

● Is driven by quantitative inputs and does not consider nonfinancial metrics

Problems based on NPV

1. Assume that ABC Inc is considering two projects namely Project X and Project Y and wants to calculate the
NPV for each project. Both project X and project Y is four-year project and cash flows of both the projects for
four years are given below:

Yea
Project A Cash Flows Project B Cash Flows
r

1. ＄5000 ＄1000

2. ＄4000 ＄3000

3. ＄3000 ＄4000

4. ＄1000 ＄6750
The firm's cost of capital is 10% for each project and the initial investment amount is ＄10,000. Calculate the
NPV of each project and determine in which project the firm should invest.

Solution:
Project A:-
Internal Rate of Return (IRR)
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential
investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in
a discounted cash flow analysis.
IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of
the project. It is the annual return that makes the NPV equal to zero.
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake. IRR
is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments
or projects on a relatively even basis. In general, when comparing investment options with other similar
characteristics, the investment with the highest IRR probably would be considered the best.

● The internal rate of return (IRR) is the annual rate of growth that an investment is expected to
generate.
● IRR is calculated using the same concept as net present value (NPV), except it sets the NPV equal to
zero.
● The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum
of annual nominal cash inflows equal to the initial net cash outlay for the investment.
● IRR is ideal for analysing capital budgeting projects to understand and compare potential rates of
annual return over time.
● In addition to being used by companies to determine which capital projects to use, IRR can help
investors determine the investment return of various assets.

Return on Investment (ROI)

Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an
investment or compare the efficiency of a number of different investments. ROI tries to directly measure the
amount of return on a particular investment, relative to the investment’s cost.

● To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The
result is expressed as a percentage or a ratio.
● Return on Investment (ROI) is a popular profitability metric used to evaluate how well an investment
has performed.
● ROI is expressed as a percentage and is calculated by dividing an investment's net profit (or loss) by its
initial cost or outlay.
● ROI can be used to make apples-to-apples comparisons and rank investments in different projects or
assets.
● ROI does not take into account the holding period or passage of time, and so it can miss opportunity
costs of investing elsewhere.
● Whether or not something delivers a good ROI should be compared relative to other available
opportunities
"Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest.
Because ROI is measured as a percentage, it can be easily compared with returns from other investments,
allowing one to measure a variety of types of investments against one another.
Understanding ROI
ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary
gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a company expects
on expanding a factory, or the ROI generated in a real estate transaction.
The calculation itself is not too complicated, and it is relatively easy to interpret for its wide range of
applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other opportunities with
higher ROIs are available, these signals can help investors eliminate or select the best options. Likewise,
investors should avoid negative ROIs, which imply a net loss.
For example, suppose Jo invested $1,000 in Slice Pizza Corp. in 2017 and sold the shares for a total of $1,200
one year later.

Problem on ROI:-

To calculate the return on this investment, divide the net profits ($1,200 - $1,000 = $200) by the investment
cost ($1,000), for an ROI of $200/$1,000, or 20%.
Formula:-
ROI:- Net Income/Investment Cost.
With this information, one could compare the investment in Slice Pizza with any other projects. Suppose Jo
also invested $2,000 in Big-Sale Stores Inc. in 2014 and sold the shares for a total of $2,800 in 2017.
The ROI on Jo’s holdings in Big-Sale would be $800/$2,000, or 40%.

Purchasing Power Parity (PPP):-

One popular macroeconomic analysis metric to compare economic productivity and standards of living
between countries is purchasing power parity (PPP).

● Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares
different countries' currencies through a "basket of goods" approach.
● Purchasing power parity (PPP) allows for economists to compare economic productivity and standards
of living between countries.
● Some countries adjust their gross domestic product (GDP) figures to reflect PPP.

S: - Exchange rate of currency 1 and currency 2

P1:- COST OF GOODS SOLD CURRENCY 1
P2:- COST OF GOODS X IN CURRENCY 2

In India, the burger price is Rs.60 (per burger) and in the US it is $ 6.

S= P1/P2

PPP= 60/6 = Rs. 10 per Dollar.