Professional Documents
Culture Documents
Chapter 3
Chapter 3
discounted cashflows
Chapter agenda
Discounting
single values
Discounting
Discounting
annuities
Time value of
money
Discounting
Compounding
perpetuities
Chapter 3
NPV Pros & Cons
Invesment
appraisal
IRR Pros & Cons
This is due to inflation, the ability to earn interest on monies received today than later,
uncertainty in the market
1. Compounding
2. Discounting
Compounding involves calculating the sum of money received at the end of the investment.
Thus it is essentially a future value calculation
𝐹 = 𝑃(1 + 𝑟)!
where
F = Future value
P = Present value
R = Interest rate per period
n = number of periods
Example – Compounding
An investor has $15,000 to invest now for 5 years at an interest rate of 10% per year.
What will be the value of the investment after five years?
Discounting
This is the opposite of compounding. This involves calculating the present value of a sum
received in the future.
In physical project undertaking, cashflows may arise at different points in time. Discounting
is crucial to bring these cash flows arisen at different points in time to the present.
𝐹
𝑃=
(1 + 𝑟)!
1
𝑇ℎ𝑖𝑠 𝑖𝑠 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑡ℎ𝑒 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟 (𝐷𝐹).
(1 + 𝑟)!
Example – Discounting - 2
An investor is expected to receive the following cashflows into the next 3 years
What is the total present value of these cash flows assuming the interest rate per annum is
10%?
It must be noted that in the context of project appraisal, the interest rate is referred to as
the cost of capital, required rate of return or discount rate.
Discounting annuities
An annuity is when the same cash flow occurs for a number of years.
Example – Annuities
You are to make $2000 payments in each of the next 3 years. If the interest rate per annum
is 5% calculate the present value of the annuity.
Year Cashflow DF @ 5% PV
𝑷𝑽 = 𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝑿 𝑨𝑭
𝟏 − (𝟏 + 𝒓)"𝒏
𝑨𝑭 =
𝒓
Alternatively, the AF can be found using the cumulative discount factor tables
Discounting perpetuities
Perpetuity is when the same cash flow is received indefinitely (to infinity).
𝐶𝐹
𝑃𝑉 =
𝑟
Example – Perpetuity
You are to receive $50 from an investment to infinity. If the discount rate is 10% what is the
PV of the perpetuity?
Growing perpetuity
The present value of a growing perpetuity is calculated as follows.
𝐶𝐹
𝑃𝑉 =
𝑟−𝑔
You are to receive $50 in 1 year’s time and the cash flow grows by 5% to infinity. If the
discount rate is 10% what is the PV of the growing perpetuity?
NPV is calculated as
If a company has two or more MUTUALLY EXCLUSIVE PROJECT, then only the project with
the HIGHEST NPV must be accepted
1. Only the cash items must be considered and all non-cash items must be ignored
2. Only relevant future cash flows must be considered
3. Sunk costs and committed costs must be ignored
The cost of obtaining a geological report on the area before a mining investment starts is an
example of sunk cost. Whether the mining op. is undertaken or not, the mining company
has to bear this cost. Thus it is sunk (already gone)
You are to undertake a small project on the factory floor that you are currently working
which has been acquired for rent. The rent here is an example of a committed cost.
Whether the project is undertaken or not, you need to bear the rent. Thus it is committed
(cannot prevent)
Example - NPV
What is the NPV of the project assuming the company has a cost of capital of 10%?
IRR is simply the discount rate at which the NPV of a project becomes zero. Thus it is the
breakeven return.
"#$!
𝐼𝑅𝑅 = 𝐷𝐶𝐹! + 𝑥 (𝐷𝐶𝐹( − 𝐷𝐶𝐹! )
("#$! &"#$" )
If IRR of the project > Cost of capital (Or hurdle rate) ---- Accept the project
If IRR of the project < Cost of capital (Or hurdle rate) ---- Reject the project
2nd step - Substitute the discount rates and NPVs to the IRR equation