Topic 2 Discounted Cash Flow Valuation

Discounted
Cash Flow
Valuation
Learning Outcomes (CLO2, CLO4)
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Copyright © 2023PNCGSBUSM
Why discounted cash flow analysis?
=
RM80 million
Why discounted cash flow analysis?
What are the expectations of future cash flows?
What are the growth opportunities for Company B?
Are the expected cash flow guaranteed or risky?
Does money lose value over time?
Are there alternative investment?
Forward-looking information
Bring the information in the future back to present
Discounted cash flow valuation
Option 1: Collect the
RM150,000 now
Option 2: Collect RM170,000 five

years from now
Which option is better?

Market interest rate is 2%
DCF to Present Value
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 !
𝑃𝑉 =
(1 + 𝑟)!
• r = discount rate
• t = the number of years you have to wait until you're entitled to the cash flow
• cash flow would be the amount you will receive at t
• PV = present value of a future cash flow
What is the present value of RM170,000 expected in five years’ time, assuming a discount rate of 2% p.a.?
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 ! 𝑅𝑀170,000 𝑃𝑉

𝑃𝑉 = 𝑃𝑉 =
(1 + 𝑟)! (1 + 0.02)" = 𝑅𝑀153,974
In TVM, to compare option 1 and option 2, you need
to compare value always at the same point in time
===> Present Value
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Option 2 is a better option
What is the present value of RM500 expected in one year’s time, assuming a discount rate of 3% p.a.?
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 ! 𝑅𝑀500 𝑃𝑉 = 𝑅𝑀485.43

(1 + 𝑟)! (1 + 0.03)#
What is the present value of RM500 expected in two years’ time, assuming a discount rate of 3% p.a.?

(1 + 𝑟)! (1 + 0.03)$
Compounding to Future Value
What is the future value of RM500 today in one year’s time, assuming a discount rate of 3% p.a.?
𝐹𝑉 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤! 𝑥 (1 + 𝑟)" 𝐹𝑉 = 𝑅𝑀500 𝑥 (1 + 0.03)#
𝐹𝑉 = 𝑅𝑀515
What is the future value of RM500 today in two years’ time, assuming a discount rate of 3% p.a.?
𝐹𝑉 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤! 𝑥 (1 + 𝑟)" 𝐹𝑉 = 𝑅𝑀500 𝑥 (1 + 0.03)$
𝐹𝑉 = 𝑅𝑀530.45
Discount Rate
• Discount rate = interest rate = cost of capital

o Risk-free interest rate
o Rates of return on similar risky investments
o Risk premia = expected return – risk free rate
• Opportunity cost : > opportunity cost à > discount rate
• Expected inflation: > expected inflation à > discount rate
• The higher the risk, the lower the present value
What is the present value of RM500 expected in one year’s time, assuming a discount rate of 12% p.a.?

(1 + 𝑟)! (1 + 0.12)#
If we put the number into the formula, we will get the PV equal to RM446.43, which is RM37 or 7.65% lower
than RM483.43, when the discount rate is 3% è the higher the risk, lower PV è when the risk is high, the
amount you are willing to invest is less toCopyright
get the©same return one year later.
2023PNCGSBUSM
Recap on Discounted Cash Flow Valuation
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Application of Financial Calculator
DCF to Present Value – one lump sum
What is the present value of RM500 expected in two years’ time, assuming a discount rate of 3% p.a.?
N I/Y PV PMT FV
DCF to Present Value - one lump sum
What is the present value of RM500 expected in two years’ time, assuming a discount rate of 3% p.a.
compounded semi-annually?
N I/Y PV PMT FV
compounded quarterly?
N I/Y PV PMT FV
compounded monthly?
N I/Y PV PMT FV
Compounding Effect.
PV
471.4
471.3
471.2
471.1
471
470.9
470.8
470.7
annually bi-annually quarterly monthly
PV
What is the future value of RM500 today in two years’ time, assuming a discount rate of 3% p.a.?
N I/Y PV PMT FV
Page 49
Constant cash flows with

Ordinary Annuity
Example: If you can afford a RM200 monthly car payment, how much car loan you can
afford if interest rates are 7 percent on a 36-month loans?
N I/Y PV PMT FV
Page 49
Constant cash flows with

Annuity Due press 2nd PMT à press 2nd ENTER à press 2nd CPT
Example: How much you needs to put aside for a series of payments of RM200 at the
beginning of every year for ten years? You are expecting to earn an interest of 2 percent
on the money you save.
N I/Y PV PMT FV
Page 52
first payment two years from today
What is the present value of a four-year annuity of RM200 per year that makes its first payment two years
from today if the discount rate is 9 percent?
N I/Y PV PMT FV
Page 45
Constant cash flows that last
Constant cash flows
Interest rate (as a decimal)
Page 47
Growing cash flows that last
Constant cash flows
Interest rate (as a decimal)
Growth rate (as a decimal)
Page 43
Continuous •
Compounding
annual interest rate

(as a decimal) Time (in years)
FV = PV e rt
Amount at the end Initial amount / e is a transcendental number
investment / principal approximately equal to 2.718
Page 43
Continuous •
Compounding
Amount at the end
!"
Initial amount /
investment / principal
PV = !"
# Time (in years)
e is a transcendental number annual interest rate

approximately equal to 2.718 (as a decimal)
Page 39 - 42
Effective Annual Rates (EAR)

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! " 𝐸𝐴𝑅 = 𝑒 -1!

𝐸𝐴𝑅 = 1 + "
-1
Resources for Topic 2
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Discounted

Option 2: Collect RM170,000 five

Which option is better?

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 ! 𝑅𝑀170,000 𝑃𝑉

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 ! 𝑅𝑀500 𝑃𝑉 = 𝑅𝑀485.43

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 ! 𝑅𝑀500 𝑃𝑉 = 𝑅𝑀471.30

𝐹𝑉 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤! 𝑥 (1 + 𝑟)" 𝐹𝑉 = 𝑅𝑀500 𝑥 (1 + 0.03)#

𝐹𝑉 = 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤! 𝑥 (1 + 𝑟)" 𝐹𝑉 = 𝑅𝑀500 𝑥 (1 + 0.03)$

• Discount rate = interest rate = cost of capital

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 ! 𝑅𝑀500 𝑃𝑉 = 𝑅𝑀446.43

Constant cash flows with

Constant cash flows with

first payment two years from today

Constant cash flows that last

Constant cash flows

Interest rate (as a decimal)

Growing cash flows that last

Constant cash flows

Interest rate (as a decimal)

Growth rate (as a decimal)

annual interest rate

Amount at the end

e is a transcendental number annual interest rate

Effective Annual Rates (EAR)

! " 𝐸𝐴𝑅 = 𝑒 -1!

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