Level I - Quantitative Methods

Discounted Cash Flow Applications

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Reproduced and republished with permission from CFA Institute. All rights reserved.

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 Contents and Introduction
1. Introduction

2. Net Present Value Internal Rate of Return Lecture 1

40 minutes
3. Portfolio Return Measurement

4. Money Market Yields Lecture 2

16 minutes

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 2. Net Present Value and Internal Rate of Return

• Net present value and internal rate of return are often applied in all
fields of finance

• Classic application is in capital budgeting where we make decisions on

how to allocate funds to long-term projects or investments

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 2.1 NPV and NPV Rule
To understand the NPV concept let us consider a simple example: You invest $40 million today on a
project which is expected to return $10 million every year for 5 years. The appropriate discount rate is
5%. Should you go ahead?

What if you realize that the initial investment is actually $45 million?

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 Practice Question 1
A project requires an initial outlay of $750,000. It is expected to produce
$200,000 in the first year, $300,000 in the second year, and $400,000 in
the third year. The cost of capital for this project is 10%. What is the NPV?
Should the project be accepted?

NPV = ∑ [CFt /(1+r)t]

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 Compute NPV Using the Financial Calculator
A project requires an initial outlay of $750,000. It is expected to produce $200,000 in the first year,
$300,000 in the second year, and $400,000 in the third year. The cost of capital for this project is 10%.
What is the NPV? Should the project be accepted?

Keystrokes Explanation Display

[2nd] [QUIT] Return to standard mode 0
[CF] [2nd] [CLR WRK] Clear CF Register CF = 0
750 [+/-] [ENTER] Initial Outlay (in 000’s) CF0 = -750
[↓] 200 [ENTER] Enter CF at T = 1 C01 = 200
[↓] [↓] 300 [ENTER] Enter CF at T = 2 C02 = 300
[↓] [↓] 400 [ENTER] Enter CF at T = 3 C03 = 400
[↓] [NPV] [10] [ENTER] Enter discount rate I = 10
[↓] [CPT] Compute NPV -19.722

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 Steps for Calculating NPV
• Identify all cash flows associated with the investment

• Determine the appropriate discount rate or opportunity cost

• Find the present value of each cash flow

• Sum all present values

NPV = ∑ [CFt /(1+r)t]

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 NPV Rule
• Independent projects
 If NPV is positive  Accept
 If the NPV is negative  Reject

• Mutually exclusive projects

 Accept project with higher NPV as long as NPV is positive

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 2.2 IRR and IRR Rule
Internal rate of return (IRR) is the discount rate that makes net present value equal to zero.

Say you invest $100 today and get $110 after one year. What is the IRR?

Invest $100 today. Get $10 at t = 1 and $110 at t = 2. What is the IRR?

NPV
. = CF0 + [CF1/(1+IRR)1] + [CF2/(1+IRR)2] + … + [CFN/(1+IRR)N] = 0

‘Internal’ because it depends only on the cash flows of the investment. It gives a sense for the return on
the project.

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 Practice Question 2
Arnold Corp wants to estimate the IRR for a proposed project. The initial investment is
$150,000. Estimated cash flows for the following 3 years are $50,000 $100,000 and
$40,000 respectively. What is the IRR?

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 Compute IRR Using the Financial Calculator
Arnold Corp wants to estimate the IRR for a proposed project. The initial investment is
$150,000. Estimated cash flows for the following 3 years are $50,000 $100,000 and
$40,000 respectively. What is the IRR?

Keystrokes Explanation Display

[2nd] [QUIT] Return to standard mode 0
[CF] [2nd] [CLR WRK] Clear CF Register CF = 0
150 [+/-] [ENTER] Initial Outlay (in 000’s) CF0 = -150
[↓] 50 [ENTER] Enter CF at T = 1 C01 = 50
[↓] [↓] 100 [ENTER] Enter CF at T = 2 C02 = 100
[↓] [↓] 40 [ENTER] Enter CF at T = 3 C03 = 40
[↓] [ÌRR] [CPT] Compute IRR 13.11%

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 IRR Rule
• Independent projects
 If IRR > Opportunity Cost  Accept
 If IRR < Opportunity Cost  Reject

• Mutually exclusive projects

 Accept project with higher IRR as long as IRR > opportunity cost

• IRR uses the opportunity cost of capital as the hurdle rate

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 Practice Problem 3
Bill is interested in a project which requires an investment of $1.5 million. The project shall pay
$200,000 per year in perpetuity. The first cash flow will be received 1 year from today. The cost of
capital is 8%. What is the IRR. Should Bill invest?

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 2.3 Problems with the IRR Rule
• The IRR and NPV rules give the same accept or reject decision when
projects are independent

• Often projects are mutually exclusive and need to be ranked

• The IRR and NPV rules might rank projects different when:
 The size or scale of the project differs
 Timing of the projects’ cash flows differs

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 NPV and IRR of Mutually Exclusive Projects
Difference in size/scale

Project Investment at t = 0 Cash flow at t = 1 IRR (%) NPV at 10%

A -100 120 20% 10
B 1,000 1,150 15% 45

Difference in timing of cash flow

Project CF 0 CF 1 CF 2 CF 3 IRR (%) NPV at 10%

A -100 120 0 0 20% 10
C -100 0 0 170 19% 28

When there is a conflict, rank/select based on the NPV rule

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 3. Portfolio Return Measurement
• As an investor you need to measure portfolio returns

• Holding Period Return (HPR)

• Two types of portfolio return measurement tools:

1. Money Weighted Return (IRR)
2. Time Weighted Return

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 3.1 Money Weighted Rate of Return
Money-weighted rate of return is effectively the IRR of the investment
Determine cash flows and then compute IRR
Example: Compute the money-weighted return for the following scenario:

Time Outlay Proceeds Cash Flow

0 $20.00 to purchase the first share
1 $22.50 to purchase the second share $0.50 dividend received on first share
2 $1.00 received ($0.50 x 2 shares) received
$47.00 received from selling 2 shares @
$23.50 per share

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 3.2 Time Weighted Rate of Return
The time-weighted return measures the compound rate of growth of $1 initially invested in the
portfolio over a stated measurement period.
Example: Compute the time-weighted return for the following scenario:
Time Outlay Proceeds
0 $20.00 to purchase the first share
1 $22.50 to purchase the second share $0.50 dividend received on first share
2 $1.00 received ($0.50 x 2 shares) received
$47.00 received from selling 2 shares @ $23.50 per share

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 Time weighted Return
• Dealing with inflows/outflows during year

• Dealing with negative return

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 TWRR - Methodology
0 1 2 3 4 5 6 7 8

10% -5% 15% -10% -20% +30% +20% 0%

• Price the portfolio immediately prior to any significant

addition or withdrawal of funds.
• Break the overall evaluation period into sub-periods
based on the dates of cash inflows and outflows.
• Calculate the holding period return on the portfolio for
each sub-period.
• Link or compound holding period returns to obtain an
annual rate of return for the year (the time-weighted
rate of return for the year).
• If the investment is for more than a year, take the
geometric mean of the annual returns to obtain the
time-weighted rate of return over that measurement
period.

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 MWRR versus TWRR
Money-Weighted Rate of Return Time-Weighted Rate of Return

Simply the IRR Compound rate of growth of $1 initially invested in

the portfolio over a stated measurement period

Return depends on timing and amount of cash Return does NOT depend on timing and amount of
flows cash flows

Appropriate performance measure if portfolio

Not an appropriate performance measure if manager does not control timing and amount of
portfolio manager does not control timing and investment
amount of investment

Appropriate measure if portfolio manager has Not an appropriate measure if portfolio manager
control over timing and amount of investment has control over timing and amount of investment

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 Practice Question 4
Mariah purchases a share worth $50 on January 1, 2011. She made a subsequent purchase on January
1, 2012 of a share worth $60. Each share paid a dividend of $3 at the end of the year. On January 1,
2013, she sold the two shares and collected $150. Compute the time weighted and money weighted
returns?

money weighted return is 28.60%

time weighted return is 27.98%

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 4. Money Market Yields

• Money market is the market for

short-term debt instruments

• Some instruments require issuer to

pay amount borrowed + interest

• T-Bills are pure discount instruments

and are quoted on a bank discount
basis

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 Different Yield Measures
• Bank Discount Yield

• Holding Period Yield

• Money Market Yield

• Effective Annual Yield

• Bond Equivalent Yield

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 Bank Discount Yield
BDY = D x 360
F t
Where
D = Face value – purchase value
F = Face value of the T-bill
t = Number of days remaining to maturity

Three issues
1. Interest not divided by investment amount
2. Simple interest
3. 360 day year

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 Holding Period Yield

HPY = P1-P0 +D1

P0
Where
Po = initial purchase price of the instrument
P1= price received for the instrument at its maturity
D1= interest paid by the instrument at its maturity

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 Money Market Yield (MMY)

MMY= HPY x 360

t
Where
HPY = Holding period yield
360 = Bank convention on number of days in a year
t = Number of days till maturity

Two issues
1. Simple interest
2. 360 day year

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 Effective Annual Yield (EAY)

EAY = (1 + HPY)365/t - 1

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 Practice Question 5
A 90-day T-bill is purchased for $990. The face value is $1,000. Compute:

1)Bank discount yield

2)Holding period yield

3)Money market yield

4) Effective annual yield

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 Practice Question 5 - Answers

Bank discount yield: [(1,000 – 990) / 1,000] x 4 = 0.04 = 4.00%

Holding period yield: (1,000 / 990) – 1 = 0.0101 = 1.01%

Money market yield: 0.0101 (360 / 90) = 0.0404 = 4.04%

Effective annual yield: (1 + 0.0101 )365/90 – 1 = 0.04160 = 4.16%

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 Yield Measure Conversions

MMY  BDY

MMY  EAY

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 Yield Measure Conversions

BDY  MMY

BDY  EAY

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 Bond Equivalent Yield
• BEY is two times the semi-annual yield

• Example: You purchase a bond for $1000. In return you’ll receive a $40
coupon every six months and the par value of $1,000 is returned at the
end of Year 4. What is the BEY?

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 Summary
• Net Present Value

• Internal Rate of Return

• Portfolio Return Measurement

• Money Market Yields

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 Conclusion

• Review learning objectives

• Examples and practice problems from the

curriculum

• Practice questions from other sources

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