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Discounted Cash Flow Applications
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Calculate PV using Excel
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Calculate PV using Excel
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Net Present Value
Net present value (NPV) is one of the important
application of the DCF concept.
NPV is the difference between the present value of
cash inflows and the present value of cash outflows
over a period of time
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Internal Rate of Return
Assumption: Cash flows are reinvested at IRR.
The internal rate of return on a project is the interest
rate that makes the NPV = 0.
If IRR ≥ discount rate (opportunity cost of the
project), we accept the project.
CF1 CF2 CFN
NPV CF0 ... 0
(1 IRR ) (1 IRR )
1 2
(1 IRR ) N
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Internal Rate of Return
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Further issues: NPV&IRR
Different size projects:
Suppose one project €10,000; another one project
€30,000 to invest.
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Further issues: NPV&IRR
Different Timing of Cash flows
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Further issues: multiple IRRs
Discount rate 6%
NPV -3.99<-- =NPV(B2,B7:B11)+B6
Two IRRs
5.00
0.00
0% 10% 20% 30% 40%
-10.00
Discount rate
-15.00
-20.00
-25.00
Summary:
• If we are comparing different size projects,
the one with the highest IRR may not add
the greatest value to the firm.
• If the timing of cash flows differ.
• If the sign of the cash flows changes more
than once, we may get more than one IRR.
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Portfolio Return Measurements
• Portfolio is a collection of securities that one
invests in.
• The idea is to diversify the risk among different
securities.
• Suppose you want to assess the success of your
investments.
• Need to consider two related but distinct tasks:
– The first is performance measurement, which involves
calculating returns in a logical and consistent manner.
– The second is performance appraisal which is, the
evaluation of risk adjusted performance.
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Different measurements of Returns
(performance measurements)
Holding
Period Return (HPR)
Money-Weighted Rate of Return
(MWRR)
Time-Weighted Rate of Return (TWRR)
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Holding Period Return
HPR is the return that an investor earns by holding a
portfolio for a specific time period. P0 is initial
investment, P1 is the price received at the end of the
holding period.
P1 P0
HPR
P0
If the dividend D1 is paid by the investment at the
end of the holding period
P1 P0 D1
HPR
P0
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Money-Weighted Rate of Return
(Similar idea as IRR)
• MWRR is the rate of return that accounts for
the timing and amount of all dollar flows into
and out of the portfolio.
• Solving the present value of cash outflows
equals to the present value of cash inflows:
PV(outflows) = PV(inflows)
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Example of MWRR
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Example Cont.
By solving below equation
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Time-Weighted Rate of Return
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To compute TWRR on a portfolio, take the
following three steps:
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TWRR
We can often obtain a reasonable approximation of
the time-weighted rate of return by valuing the
portfolio at frequent, regular intervals.
• The more frequent the valuation, the more accurate
the approximation.
• We compute 365 such daily return and link them
to get annual return.
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Annualized TWRR
If the investment is for more than one year?
rTW (1 r1 ) (1 r2 ) (1 rN )
1/ N
1
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Annualized TWRR
Suppose that the portfolio earned returns of 15
percent during the first year and 6.67 percent during
the second year, what is the portfolio’s time-weighted
rate of return over an evaluation period of two years?
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Money Market
Money market is the market for short-term debt instrument
(one year maturity or less).
A very good example of a short-term debt instrument is a
treasury bill. T-bills are pure discount instruments (pays no
income until maturity, whereupon the investor receives the
face value of the instrument . These instruments are issued at
a price lower than face value).
T-bills are quoted on a bank discount basis, rather than on a
price basis.
D 360
rBD
F t
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Bank discount yields
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Holding Period Yield
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Example Computing EAY
Suppose an investment of $98,000 will pay
$100,000 in 150 days. What is the EAY?
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Money Market Yield
The money market yield convention makes the
quoted yield on a T-bill comparable to yield
quotations on interest-bearing money-market
instruments that pay interest on a 360-day
basis.
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Money Market Yield
Find the money market yield for the T-bill in
Example 2-6.
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