Lesson 3

More on cash flows

Learning objectives
You will cover more on time value of money in this topic. This topic will feature
more advanced annuity problems. After completing this module, you should be
able to:
 calculate the present value of a deferred annuity
 calculate present values of perpetuities
 calculate and interpret the net present value
 identify financial cash flows and discount rates
 calculate and interpret the impact of tax, inflation and risk on cash flows and
discount rates
This topic also introduces you to the important concept of net present value. The
net present value is an important criterion that is used in evaluating investments.
It is one of the most useful tools in a financial manager’s arsenal. We will also
briefly cover the impact of tax and inflation on cash flows and your investment
decision.

Introduction
In the first topic, the emphasis was on time value of money. It is important that
you are competent in finding the future or the present value of any sum of money
at any point on the time line. If you are still not too sure about your calculations,
it would be worth your while to go through the first two modules before you start
this one. The purpose of being fluent in our calculations is that it will enable us to
evaluate investments. A financial investment is simply a promise of future
benefits derived from some initial outlay. These future benefits are usually in the
form of cash flows. Hence, a financial investment or project involves a series of
cash flows that occur in the future. Hence, we need to value these cash flows that
occur at different points in time. We will start this module by looking at a
deferred annuity and perpetuities.

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Deferred annuity
A deferred annuity is a series of payments that start any time after the first period.
For example, if the annuity starts at the end of year 3, the annuity is said to be
deferred by 3 years. Calculating the present value of a deferred annuity is similar
to what we have done before. We just have to bear in mind that the annuity is
deferred and that we need to make a little adjustment to get the present value.

Activity 3.1
What is the present value of payments of $1000 per year for 4 years if the first
payment starts at the end of the 4th year? Interest is 10% p.a.
The time line for the above will be:

0 1 2 3 4 5 6 7

1000 1000 1000 1000

3169.87

If we ignore the first three ticks on the time line, the above looks just like an
ordinary annuity. If we use the formula for the present value of an ordinary
annuity, the answer will fall in time 3. If you use the present value formula, the
answer will fall one period prior to the commencement of the cash flow. Also
notice that the time line stops at year seven. If you had attempted the problem
without drawing the time line, you might have thought that there were eight
periods to be considered!

PV =PMT [
1−( 1+i )−n
i ]
PV =1000 [
1− ( 1+0. 10 )−4
0.1 ]
¿ 3169 . 87
The value 3169.87 falls in time 3, therefore you need to bring it back to time zero
by discounting it back by three periods:
PV =3169(1 .1 )−3
¿2381 .56
Hence, the value of the cash flows at time zero is 2381.56
The formula for the present value of a deferred annuity can be given as:

PV = [ PMT [ 1−(1+i)−n ]
i ]
( i+i )−(d−1)

where, d is the deferred period. For the activity that we just did, d will be 4.

Perpetuities
Perpetuities are payments of the same amount that go on forever. An example of
perpetuity is a scholarship. If you set up a scholarship under your name, you
would like it to last forever. The question is, what amount of money set aside
today will allow you to withdraw an equal amount forever?
Before we answer this question, we need to distinguish between the different
types of perpetuities. These are similar to the types of annuities and depend on
when the first payment falls.

Ordinary perpetuity
Here, the perpetuity starts at the end of the first period.

0 1 2 3 …

PMT PMT PMT …

The present value of an ordinary perpetuity can be calculated as:

PMT
PV =
i

Perpetuity in due

0 1 2 3 …

PMT PMT PMT PMT …

The present value of perpetuity due is calculated as:

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 PMT (1+i)
PV =
i

Deferred perpetuity

0 1 2 3 …

PMT PMT …

The present value of a deferred perpetuity is given as:

−( d−1)
PMT (1+i)
PV =
i

Activity 3.2
An investment company is expected to pay a dividend of $7.50 every 6 months
indefinitely on a preference share. If money is worth 18% per annum
compounded semi-annually, what should an investor be willing to pay for a
preference share:

Just after the dividend has been paid:

PMT
PV =
i
7 . 50
=
0. 09
PV = 83.33

Just before a dividend is due to be paid:

 PV = 90.83
PMT (1+i)
PV =
i
7 . 50(1 .09 )
=
0. 09

Activity 3.3
You wish to set up a scholarship that pays the top student in the finance course
$1000. Assuming that this scholarship is to last forever and that interest is 10%
per annum, how much must be set aside today if the scholarship is to start in 4
years time?

PMT (1+i)−(d−1)
PV =
i
−( 4−1)
1000(1 .1 )
¿
0.1
¿ 7513 .14

This section marks the end of annuities and perpetuities. You should practice
some of the activities without looking at the solution. Remember that a time line
is a very good way of visualising the problem. Also it would be useful to first
identify the different cash flows and assign the proper notations to them. For
example, write down what the PMT is, the n is and the I is, before you start the
problem.

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Understanding net present value (NPV)
It is perhaps very appropriate to introduce the concept of net present value at this
point. The net present value is an application of the present value concept. It is
used in evaluating investments. This calculation will be used extensively in the
later modules. It is important to understand intuitively the meaning of net present
value.
An example:
Let us assume that an investment proposal promises the following cash flows:

0 1 2 3

100 200 300

The above investment promises you $100 in year one, $200 in year two and $300
in year three. How much would you pay for such an investment? Would you pay
$400 for this investment?

From your knowledge of time value of money you can see that we cannot
compare the $400 with the cash flows that occur at different point in time. Also,
you will naturally be asking what the interest rate is. Let us assume that the
interest rate is 10% per annum. To arrive at a decision, we need to bring to
present value the cash flows and compare the answer to the initial outlay of $400.

0 1 2 3

100 200 300

The present value of the cash flows is:

 CF 1 CF 2 CF 3
PV = + +
(1+i )1 (1+i )2 (1+i )3
100 200 300
¿ 1
+ 2
+ 3
(1+0 . 1) (1+0 . 1) (1+0 .1 )
¿ 481 . 59

Hence, the value of the investment today is 481.59. Since the present value of the
investment is bigger than what is being asked for it ($400), it is a good
investment. That is, if the initial outlay is less than the present value of the
investment, you will be paying less than what it is actually worth. The difference
between the present value of the cash flows and the initial investment is what we
call the net present value.
The net present value is thus:
CF 1 CF 2 CF n
NPV = + +.. .+ −I
( 1+i )1 ( 1+i )2 ( 1+i )n 0

Where
I 0 is the initial investment.
Thus for the problem above:
CF CF CF
NPV = 1 1 + 2 2 +.. .+ n n −I 0
(1+i) (1+i) (1+i)
100 200 300
¿ 1
+ 2
+ 3
−400
(1+0 . 1) (1+0 . 1) (1+0 .1 )
=+ 81. 59

Notice that if the asking price for this investment were $500, it would have
produced a negative NPV. Hence, the rule is that it is a good investment if the
NPV is positive and a bad investment if the NPV is negative. The net present
value measures the increase in wealth.
The variables for the net present value calculations are:
CF - Cashflow
i - Required rate of return
n - The number of cashflow
also
Timing of cashflow
In the topics that follow, we will look at how to define each of these variables.
NPV calculations are very important in project evaluations. However, your
output (NPV) is only as good an estimate as the quality of your inputs (variables).

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What is a cash flow?
In the topics that follow you will have to decide what constitutes a financial cash
flow. It is important that you understand what is financial cash flow is, as it
differs from an accounting cash flow. Cash flows are usually based on projections
or forecasts of revenue and expenses from sales and production.
A rule of thumb in finance is to consider actual cash flows coming in and going
out of a project. Any cash flow, which are just book entry adjustments are usually
not considered as a financial cash flow.
Some point on cash flows:
 In finance we only consider actual cash coming in and going out of a project.
 Look at incremental cash flows.
 Do not include sunk costs.
 Consider opportunity costs.
 Depreciation is not a cash flow but the tax shelter from depreciation is a cash
flow.
Your textbook reading should further clarify the points made above. The
important thing to note is that a book adjustment is usually not considered a cash
flow as there is no physical inflow or outflow of cash.
Depreciation falls under this category. Depreciation is the decrease in the book
value of an asset. There is no cash flow that actually leaves the project. However,
because you incur loss in your asset (depreciation), the tax department
compensates you for the loss (tax shelter). The compensation for the loss is a cash
flow.

Treatment for taxation

We have to treat cash flows for taxation. Tax is a cash flow between the company
and the tax department. All revenue and expense must be considered on an after-
tax basis. Yes, even expenses, as will be explained later.
Whenever you are given revenue or an expense, you need to deduct tax from it.
Activity 3.4
A company’s revenue is $20,000 and its expense is $10,000. If the company tax
rate is 40% what is the after-tax cash flow?
The usual calculation Alternatively

Revenue: 20 000 a/t Revenue:

t
20 000(1- c ) 12 000

Expense: -10 000 a/t Expense: 10 000(1-

t c ) -6 000
------- -------
Net cash flow: 10 000
Tax: -4 000
Net a/t c/f: 6 000 Net a/t c/f: 6 000
*a/t refers to after-tax
c/f refers to cash flow
The calculation on the left is the usual way of working out the net cash flow. On
the right, the after tax amount for the revenue and the expense is calculated first.
Then the after-tax cash flow is calculated. Both the left and the right hand side
calculation will give you the correct after-tax amount. Notice how tax is applied
to both the revenue and the expense on the right hand side.

General treatment of cash flows for tax

Here are some rules for treating cash flows.
All incomes and expenses are cash flows; therefore we need to take the after-tax
amount.

Income x (1-
tc ) = net inflow

Expenses x (1- c )
t = net outflow
For all non-cash flow items like depreciation, we that the expense and multiply it
with the tax rate:
t
Expense x c = net cash inflow
 Example: if depreciation is $20 000 then tax shelter on depreciation is
depreciation x
tc
We will look at this in detail in the later modules.
It is important to note that the purchase of an asset is considered capital in nature
and must therefore be depreciated. The treatment for tax is discussed in the next
module.

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Treatment for inflation (consistency principle)
Inflation is an important consideration when evaluating an investment. Inflation
reduces the value of our fixed investment. We can adjust for inflation in two
ways:
1. Inflate cash flows and find NPV using nominal discount rate
or
2. Use uninflated cash flows and find NPV using real (adjusted) discount rate

This is the consistency principle. If we use nominal cash flow (cash flow with
inflation included), we have to use a nominal discount rate (discount rate with
inflation included. If we use a real cash flow (with inflation excluded), we have
to use a real discount rate (discount rate with inflation excluded).

Activity 3.5
An investment of $1000 is expected to generate cash flows of $500 at constant
prices, at the end of each year for 3 years. If inflation rate is at 10% per annum,
and the nominal cost of capital is 15% per annum, find the NPV of the
investment.
 Using 1st method:
Inflate the cash flows and use nominal rate

CF CF CF
NPV = 1 1 + 2 2 +.. .+ n n −I 0
(1+i) (1+i) (1+i)
500(1 .1 ) 500(1 .1 ) 500(1 .1 )3
2
¿ + + −1000
(1+0 . 15 )1 (1+0 . 15)2 (1+0 . 15)3
¿ 373

 Using the 2nd method:

Use the real cash flow and deflate the discount rate.

We need to first find the real discount rate. This is done as follows:
 (1+nominal )
(1+real )=
(1+inflation )
(1+nominal )
real= −1
(1+inflation )

(1+0. 15 )
real= −1
(1+0. 1)
=0. 0455

CF CF CF
NPV = 1 1 + 2 2 +.. .+ n n −I 0
(1+i) (1+i) (1+i)
500 500 500
¿ 1
+ 2
+ 3
−1000
(1+0 . 0455 ) (1+0. 0455 ) (1+0 .0455 )
¿ 373

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Formulas used
Present value of a deferred annuity

PV = [
PMT [ 1−(1+i)−n ]
i ]
( i+i )−(d−1)

Present value of an ordinary perpetuity

PMT
PV =
i

Present value of perpetuity due

PMT (1+i)
PV =
i

PMT (1+i)−( d−1)

PV =
i
Present value of a deferred perpetuity

Net present value

CF 1 CF 2 CF n
NPV = + +.. .+ −I
( 1+i )1 ( 1+i )2 ( 1+i )n 0

Real and nominal interest rate

(1+nominal )
(1+real )=
(1+inflation )
(1+nominal )
real= −1
(1+inflation )
Reflecting on what you have learned
Write a short paragraph on the following:
What is a perpetuity?

What do you understand by the net present value?

How does a financial cash flow differ from an accounting cash flow?

What is the difference between a real interest rate and a nominal interest
rate?

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