2-Discounted Cash Flow Applications

Discounted Cash Flow Applications
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Time Value of Money Applications
Peter is Project Finance Manager Net present value (NPV) and internal rate of return (IRR) are tools for :
at ABC Ltd and is deliberating on ❑ evaluating stream of cash flows,
the below proposals:
(a) Investment in a 100km road ❑ Measurement of portfolio return,
project for a tenure of 10 years? ❑ and calculation of money market yields.
(b) Investment in a 100MW solar
power project for a tenure of 6 Three chief areas of financial decision-making in most business
years?
Working
Though both the investments Capital Capital Capital
have strong credentials, but they Budgeting
have different risk profiles and
Structure Management
cannot be compared directly. • Allocation • Choice of • Manageme
He needs to make a financial of funds to long-term nt of the
decision and needs a standard
relatively financing , company’s
metric to compare both the
proposals and come up with an
long term company short-term
answer: projects. wants to assets and
make. liabilities.
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Net Present Value
Peter wants to evaluate the investment in a 100km road project A company should choose those capital investment
for a tenure of 10 years processes that maximize shareholder’s wealth.
To complete the Project, Company will have to expend resources The Net Present Value (NPV) of an investment, is
such as construction, land acquisition, etc. These would be cash the present value of cash inflows minus the
outflow for the Company. Let us assume the road can be
constructed within 1 year period.
present value of cash outflows.
On completion of the road, the Company will earn toll revenues NPV Rule :
for a period of 10 years. These would be cash inflows for the ❑ Company should accept the project if NPV is
Company or the revenues. Let us assume digitization efficiency positive and reject the project if NPV is
does not entail any costs for toll collection negative.
❑ A positive NPV suggest that cash inflow
To make a decision Peter has to plot all the cash inflows, discount
them with a required rate of return and compare the cumulative outweigh cash outflow on present value basis.
present value of the cash inflows with the cash outflow. ❑ If, the company must choose between two,
Net Present Value is the difference between the cumulative mutually exclusive project ,the one with higher
present value of all the future cash flows and the initial cash NPV should be chosen.
outlays

Net Present Value…
Mr Reddy decides to invest $100

Steps in computing NPV :
into a project which will generate ❑ Identify all cash flows associated with the investment.
$30 for next years and $40 for
another two years. If the discount ❑ Determine the appropriate discount rate or opportunity cost .
rate for him is 10%, what is the NPV ❑ Using the discount rate , calculate the present value of each cash flow.
on the investment?
❑ Sum of all present values, is the investment’s net present value.
Step Screen Remark
❑ Apply NPV rule.
1 ON Start
Formula :
2 2ND -> CLR WORK Erase earlier data CF1 CF2 CF3 CFn
3 CF -> -100 -> ENTER First cash flow (negative)
NPV = CF0 + + + + ….. +
(1+r) 1 (1+r)2 (1+r)3 (1+r)n
4 Go to next cash flow
5 30 -> ENTER -> Second cash flow (+ve)
t=n CFt
6 2-> ENTER -> Cash flow of 30 is for
next 2 subsequent years Where,
NPV = ∑ t To Remember
t = 0 (1+r)
7 40 -> ENTER -> Fourth cash flow (+ve)
❑ CFt = after tax cash flow at time t ✓Invest if NPV > 0
8 2-> ENTER -> Cash flow of 40 is for
next 2 subsequent years ❑ N = the investment’s projected life
9 NPV -> 10 -> ENTER Enter discount rate and ❑ r = required rate of return ✓Do not invest if NPV < 0
-> -> CPT get the NPV

Internal Rate of Return
Peter also wants to evaluate investment in a

100MW solar power project for a tenure of 6 years The Internal Rate of Return (IRR) is that discount rate, which
makes the net present value equal to zero.
So, solar panel installation costs would be cash
outflows and panels can be installed within 1 year Formula :
Peter can have a contract with Govt to purchase
Initial CF1 CF2 CF3 CFn
the electricity at a certain per kW rate and = + + + ….. +
revenues generated by of the contract would be Investment (1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)n
cash inflows. Again, assuming there is no
maintenance or costs involved in electricity Initial t=n CFt
generation = ∑
Investment t = 1 (1+IRR)
t
To make a decision Peter decides to plot all the

cash inflows and discount them with such rate of
return, so that the cumulative present value of all
Where,
the cash inflows is equal to the initial cash outflow. ❑ CFt = after tax cash flow at time t To Remember
This Internal Rate of Return is the discount rate ❑ IRR = Internal Rate of Return ✓Invest if IRR > r
which equalize the cumulative present value of all ❑ r = discounting rate
the future cash flows. ✓Do not invest if IRR < r
Internal Rate of Return
Mrs Ghosh has been provided with an investment Step Screen Remark
opportunity to invest $100 in a 3 year bond which will
1 ON Start
provide the following cash flows:
2 2ND -> CLR WORK Erase earlier data
Year 1: $ 20
3 CF -> -100 -> ENTER First cash flow (negative)
Year 2: $ 20
4 Go to next cash flow
Year 3: $ 90 5 20 -> ENTER -> Second cash flow (+ve)
6 2-> ENTER -> Cash flow of 20 is for next 2 subsequent years
What is the Internal Rate of Return on this investment 7 90 -> ENTER -> Third cash flow (+ve)
opportunity for Mrs Ghosh?
8 1-> ENTER -> Cash flow of 90 is for next 1 year
9 IRR -> CPT Compute the IRR

Problems with the IRR rule
High IRR
Certainty of realizing IRR assumes every cash flow is re- This may be unrealistic and is
Check IRR invested at IRR. subject to availability of
other Accept lucrative investment
IRR is used to discount all the cash opportunities during the
factors
flows hence intermediate cash project tenure
-ve +ve flows are hence inherently
NPV NPV
assumed to get re-investment at
Check the IRR.
Reject other
IRR and NPV presents Accept NPV based method NPV method is more reliable
Other factors
factors
contradicting results as it is based on absolute
value
Low IRR - There may be multiple IRRs if the cash flows are erratic (cash in-flows/ outflows are mixed:
more than one sign +/- change)
- When there are mutually exclusive projects (only one project can be undertaken), then IRR
may provide conflicting results compared to NPV based results

Holding Period Return ( Total Return)
A Holding Period
Return can be for any Holding Period Return (HPR) measures the total return, for holding an
period of time. It investment, over certain period of time.
simply computes the
return for the period in Formula :
which the instrument
was held – it can be
days, weeks, month or
several years!
Where,
❑ P0 = initial investment
❑ P1= price received at the end of holding period,
❑ D1= cash paid by the investment at the end of holding period.

Holding Period Return (Total Return)
Example :
Eicher Motors is currently trading at Rs 25,040. If you purchased the stock exactly one year ago
for Rs. 18,694 and received dividend Rs. 100 over the course of the year. What is your holding
period return.
Solutions :
25,040 - 18,694 + 100

18,694
HPR = = 34.48%

Money-Weighted Rate of Return
Is essentially the Internal Rate of Return(IRR).

The approach considers timing and amount of cash flows.
If the funds are added to the portfolio when the portfolio is performing
well (poorly) , the money-weighted rate of return will be higher (lower)
than weighted average return.
Example :
❑ Mr. Chopra bought a share of HUL stock for Rs. 185 on December
31,2007. On December 31,2008 he bought another share for Rs.
225. On December 31,2009 he sold both shares at Rs. 275 each.
The stock paid dividend of Rs. 7 at the end of each year.
❑ What is the money-weighted rate of return?

Money-Weighted Rate of Return…
Solutions:
PV ( outflow ) = PV ( inflow ) Using Financial Calculator (TI BAII)
Press
Steps Remarks
Buttons
1 2ND Selects the second function of the calculator
225 7 550 14 2 CLR WORK Clears memory
185 + = + + 3 CF CF0 appears on screen
(1+r) (1+r) (1+r)2 (1+r)2 4 -185 Number fed on the screen
5 ENTER Number stored in the CF 0 memory location
Solve for r 6 ? Selects the next memory location
Number fed on the screen and stored in CF1
7 -218
memory location
218 564 8 ENTER Number stored in the CF 1 memory location
0 = -185 - + 2 9 ? Selects the next memory location
(1+r) (1+r)
10 ? Selects the next memory location
Number fed on the screen and stored in CF1
11 564
Using TI BAII Professional Calculator memory location
12 ENTER Number stored in the CF 2 memory location
13 IRR Puts the calculator in IRR computation mode
r = 25.36% 14 CPT Computes the IRR for the given stream of cash

Time-Weighted Rate of Return
The Time-Weighted Rate of Return measures the

compound growth rate of $1 initial investment over the
measurement period.
To compute exact time-weighted rate of return, take the
following 3 steps :
❑ Split the overall measurement period into sub To Remember
periods based on the dates of cash inflows and
✓Time weighted rate of
outflows.
❑ Calculate the Holding Period Return for each sub return is a preferred
periods. performance measure
❑ Calculate the time-weighted rate of return, in the investment
❑ If measurement period < 1 , compound holding industry.
period returns to get annualized rate of returns
for the year.
❑ If measurement period > 1 , take the geometric
mean of the annual returns.
Example :
Mr. Chopra bought a share of HUL stock for Rs. 185 on December 31,2007. On
December 31,2008 he bought another share for Rs. 225. On December 31,2009 he
sold both shares at Rs. 275 each. The stock paid dividend of Rs. 7 at the end of each
year.
What is the time-weighted rate of return?

Solution Year 1
Beginning Value = 185*1 = 185
Ending Value = 225 + 7 = 232
Returns = 232/185 - 1 = 25.41%
Year 2
Beginning Value = 225*2 = 450
Ending Value = 275*2 + 2*7 = 564
Returns = 564/450 - 1 = 25.33%
Time Weighted Return
(1/2)
= [ (1+25.41%) * (1+25.33%) ] -1
= 25.37%

Example
Compute the investment performance of Sunflower Fund during 2009.

The facts are as follows:
❑ 1 Jan, 2009 Market Value = $10 million
❑ 1 May 2009 Stocks in the fund showed a gain of $1 million
❑ 1 May 2009 Stocks in the fund received a dividend of $0.2 million
❑ 1 May 2009 additional amount of $2 million invested in the fund and
AUM became $13.2 million
❑ 31 Dec 2009 total dividend received = $0.25 million
❑ 31 Dec 2009 market value of fund was $14 million
Based on above information,
❑ Compute Sunflower Fund ‘s TWROR (Ans.: 20.909%)
❑ Compute Sunflower Fund ‘s MWROR (Ans.: 19.925%)

Solution
– – Market Value of
Gains from Stocks fund
$ 1 million $ 14 million
– Dividends – Dividends
Inflows received from received from
Stocks Stocks
$ 0.2 million $ 0.25 million
1-Jan-09 1-May-09 31-Dec-09
– Initial – Reinvestment of
Investment $ Gains from Stocks
10 million $ 1 million
– Reinvestment of
Dividends
Outflows received from
Stocks
$ 0.2 million
– Additional
investment in
Stocks
$ 2 million
Total AUM = $ 10 Total AUM = $ 13.2 Total AUM = $ 14.25

million million million

Solution…
MWROR TWROR
P1 - P0 + D1
PV ( outflow ) = PV ( inflow ) HPR =
P0
1 0.2 2 1 0.2 14 0.25
10 + + + = + + 3 + HPR1 = 11 + 0.2 - 10 = 12%
(1 + r) (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) (1 + r)3
10
2 14.25
0 = - 10 - +
(1 + r) (1 + r)3
Solving for r, as a simple IRR problem HPR2 = 14 + 0.25 - 13.2 = 8.0%

13.2
r = 6.2436%
Anualise the number the rate,

MWROR = (1 + r)3 - 1 TWROR = (1+HPR 1)*(1+HPR 2) - 1 = 0.209
= (1 + 6.2436%)3 - 1
MWROR = 19.92% TWROR = 20.909%

Different yield measures of U.S. Treasury Bill
Money market instruments are low-risk, highly liquid debt instruments,

with a maturity of one year or less.
There are two types of money market instruments,
Interest Pure
Bearing Discount
Instruments Instruments Pay interest as the
Issuer repays the
difference between
lender, the amount
the amount borrowed
borrowed plus
and the amount paid
interest.
back.
e.g. Bank certificates e.g. U.S. Treasury

of deposits Bill

Bank Discount Yield
Pure discount instruments such as T-bills are quoted differently from U. S.

government bonds.
They are quoted on Bank Discount basis, rather than price basis.
Formula :
D 360
rBD = *
F t
Where,
❑ rBD = the annualized yield on a bank discount yield.
❑ D = the dollar discount.
❑ F = the face value of the T - bill.
❑ t = the actual number of days remaining to maturity.
❑ 360 = bank convention of the number of days in year.

Bank Discount Yield…
Example :
Points to Remember :
Suppose a T-bill is selling at $ 96,750 with a face value
of $100,000 and 175 days to maturity. What is the ✓It is based on face value,
bank discount yield? not on a purchase price.
Solution :
✓It is annualized using
The dollar discount , D , is $ 3250 ( $ 100000 - $ 96750) 360-days year , not on
So, 365-days year.
✓It is annualized using

$3,250 360 simple interest , and
rBD = *
$100,000 175 ignores the compound
interest.
rBD = 6.686%

Effective Annual Yield ( EAY )
The Effective Annual Yield is the annualized HPY on the basis of 365-
day year and incorporate the effect of compounding interest.
Formula :
EAY = (1 + HPY)365/t - 1
Example:
Suppose a T-bill is selling at $ 96,750 with a face value of $1,00,000 and
175 days to maturity. What is the EAY?

Effective Annual Yield ( EAY )…
Solution :
100000 - 96750
HPY = = 3.35917%
96750
EAY = (1 + 0.0335917)365/175 - 1
EAY = 7.13416%

Money Market Yield
Money Market Yield ( is also known as CD Equivalent Yield ) is the

annualized HPY on the basis of 360-day year and uses simple interest.
Formula :
Discount 360
rMM = X
Investment t
◦ Where,
◦ rMM = Money market yield.
◦ BDY = Bank discount yield.

Money Market Yield…
Example :
❑ An investor buys a $ 1000 face value T-bill due in 60 days at a price
of $ 990.
❑ Calculate BDY , HPY , EAY and MMY?

Money Market Yield…
Solution : Tips:
✓ If we know HPY , then:

(1000 - 990) 360 (1000 - 990)
BDY = * HPY =
1000 60 990 EAY = (1 + HPY)365/t - 1
HPY * 360
rMM =
= 6% = 1.0101% t
✓ If we know EAY , then :
(1 + 1.0101%)365/60-1 (360 * 6%) HPY = (1 + EAY)t/365 - 1

EAY = MMY =
(360 - 60 * 6%)
t/365
rMM = [(1 + EAY) - 1 ] * (360/t)
= 6.3047% = 6.0606%
✓ If we know rMM, then:
HPY = rMM * (t / 360)
EAY = (1 + rMM * t/360) 365/t - 1

Bond Equivalent Yield
Bond Equivalent Yield = 2 × semiannual discount rate

Convert a HPY of 3% for 3 months into a Bond Equivalent Yield
❑ Semiannual Rate = (1.03)2 (Convert 3 months into 6 months)
❑ Semiannual Rate = 6.09%
❑ Bond Equivalent Yield = 2 ×6.09 = 12.18
BEY is semi-annual effective (as it convers semi-annual rate into annual

by multiplying by 2) and is largely used in Government Bonds, which
pays semi-annual coupon.

Comparison
Yield Pros Cons Usage

EAY Uses 365 days Not a quoted rate By analysts to compare various
Compounds and needs to be instruments and to conduct
Uses purchase price calculated analytical calculations/research
BEY Easy to use and Does not compound This yields are quoted in the
interpret/compare newspapers for most fixed income
across different fixed securities
income securities
MMY Easier to compare with Does not compound Used between banks in the money
T-bill quotes Uses 360 days markets (inter-bank transactions)
BDY Simple to calculate Does not compound Treasury Bills
Uses 360 days
Uses Face Value

Recap
Yield Based on Annual Compounding No. of Days

HPY Price No No Held Till Maturity
EAY Price Yes Yes 365
MMY Price Yes No 360
BDY Face Value Yes No 360
Yield Basis
MWRoR IRR
TWRoR Geometric Return

Practice Question
1.An investor buys a share of stock for $52.68 and receives an $0.88 dividend one year later. If the share sells
for $57.50 just after the dividend payment, the holding period return is closest to:
A) 9.1%.
B)9.9%.
C)10.8%.
2.A portfolio manager pays $99,500 for a 182-day US T-bill with face value of $100,000. The T-bill will be held
to maturity. A yield of 0.5025% calculated for this T-bill when it is purchased is most accurately described as
the:
A)bank discount yield.
B)money market yield.
C)holding period yield.

Practice Question
3.A 123-day T-bill with a maturity value of $100,000 is priced at $99,620. The bill’s effective annual yield
is closest to:
A)0.38%.
B)1.12%.
C)1.14%.
4.For a T-bill purchased at $97,000 that matures at $100,000 in 300 days, which of the following yields
is closest to 3.71%?
A)Money market yield
B)Holding period yield (HPY)
C)Effective annual yield

Practice Question
5.A 223-day T-bill with a maturity value of $100,000 has a bank discount yield of 2.05%. The bill’s holding
period yield is closest to:
A)1.29%.
B)2.08%.
◦ C)2.11%.
6.Given a 300-day holding period yield (HPY) of 7%, the effective annual yield (EAY) is closest to:
A)8.4%.
B)8.5%.
C)8.6%.

Solution
1.C is correct. The formula for the holding period return is

P1−P0+D1/P0
where P0 is the initial investment, P1 is the final value at the end of the holding period, and D1 is the cash
dividend paid at the end of the holding period. This investment results in a holding period return (HPR) of
HPR=$57.50−$52.68+$0.88/$52.68=10.82%
2. C is correct. The 182-day holding period yield (HPY) is calculated as follows:
HPY=P1−P0+D1P0=$100,000−$99,500$99,500=0.5025%
3.C is correct. The effective annual yield (EAY) is calculated as follows (where HPY is holding period yield):
HPY=P1−P0+D1P0=$100,00−$99,620$99,620=0.3814%
EAY=(1+HPY)365/123−1=(1+.003814)365/123−1=1.1362%

Solution
4.A is correct. The money market yield is equal to the annualized HPY, assuming a 360-day year. rMM =
(HPY)(360/t). A T-bill purchased at $97,000 has a HPY of [($100,000 – $97,000)/$97,000] = 3.09%. The
money market yield for this T-bill is (3.09%)(360/300) = 3.71%. The effective annual yield for this T-bill is (1 +
0.0309)365/300 – 1 = 3.77%.
5.A is correct. The holding period yield of a bill can be computed from the bank discount yield by finding the
bill’s discount D:
rBD=DF×360t, so 0.0205=D$100,000×360223
Solving for D results in a discount of $1269.86. This result implies a purchase price of $100,000 – $1,269.86 =
$98,730.14.
The holding period yield (HPY) then computes as:
HPY=$1,269.86$98,730.14=1.286%
6.C is correct. The EAY is one plus the HPY, compounded forward one year, and then subtract one:
EAY = (1 + HPY)365/t – 1
(1 + 0.07)365/300 – 1 = 8.58% ≈ 8.6%

2-Discounted Cash Flow Applications

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Discounted Cash Flow Applications

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Mr Reddy decides to invest $100

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Peter also wants to evaluate investment in a

To make a decision Peter decides to plot all the

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25,040 - 18,694 + 100

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Is essentially the Internal Rate of Return(IRR).

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The Time-Weighted Rate of Return measures the

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Ending Value = 225 + 7 = 232

Returns = 232/185 - 1 = 25.41%

Ending Value = 275*2 + 2*7 = 564

Returns = 564/450 - 1 = 25.33%

Time Weighted Return

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Compute the investment performance of Sunflower Fund during 2009.

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1-Jan-09 1-May-09 31-Dec-09

Total AUM = $ 10 Total AUM = $ 13.2 Total AUM = $ 14.25

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Solving for r, as a simple IRR problem HPR2 = 14 + 0.25 - 13.2 = 8.0%

Anualise the number the rate,

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Money market instruments are low-risk, highly liquid debt instruments,

e.g. Bank certificates e.g. U.S. Treasury

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Pure discount instruments such as T-bills are quoted differently from U. S.

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✓It is annualized using

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Money Market Yield ( is also known as CD Equivalent Yield ) is the

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✓ If we know HPY , then:

✓ If we know EAY , then :

(1 + 1.0101%)365/60-1 (360 * 6%) HPY = (1 + EAY)t/365 - 1

HPY = rMM * (t / 360)

EAY = (1 + rMM * t/360) 365/t - 1

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Bond Equivalent Yield = 2 × semiannual discount rate

BEY is semi-annual effective (as it convers semi-annual rate into annual

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Yield Pros Cons Usage

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Yield Based on Annual Compounding No. of Days

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1.C is correct. The formula for the holding period return is

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Ending Value = 2752 + 27 = 564