Financial Management Assignment 1

Submitted by: Humaira Shafiq STD: 2012-3-49-14004 Submitted to: Mr. Rizwan Siddiqui

Relationship of interest rates and cash flows

The interest rate used in determining the present value of future cash flows. The interest rate used in discounted cash flow analysis to determine the present value of future cash flows. The discount rate takes into account the time value of money (the idea that money available now is worth more than the same amount of money available in the future because it could be earning interest) and the risk or uncertainty of the anticipated future cash flows (which might be less than expected). The process of finding present values is called Discounting and the interest rate used to calculate present values is called the discount rate. In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process taking cash flows and a price and inferring a discount rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

Relationship between IRR and NPV

Net present value, or NPV, and internal rate of return, or IRR, are measures that you can use to evaluate a potential capital project or investment. With both IRR and NPV, you evaluate a stream of expected cash inflows and outflows to help determine if you should make a specific investment. The IRR indicates the potential growth percentage of the investment. The NPV, on the other hand, indicates the value of a project's income potential today. Calculations Although the calculations for both the IRR and the NPV utilize the same data, the IRR gives insight into the potential profitability of an investment when the NPV still equals zero. The IRR is also commonly known as the discount rate. When you compare potential investments, a higher IRR usually indicates a better investment choice.

Amounts of Return Consider the minimum rate of return you find acceptable. For an investor, the IRR must at least equal the minimum amount of return expected for a particular investment. If the IRR does not meet this minimum, look for another investment. The NPV, on the other hand, shows the investment's value in today's dollars. The NPV will equal zero if the investment's future discounted income, minus the initial cash outflow of the project, does not carry any present-day value.

Short Notes on IRR and Modified IRR

'Internal Rate Of Return - IRR' The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. The formula for IRR, using this example, is as follows:

Where the initial payment (CF1) is $200,000 (a positive inflow) Subsequent cash flows (CF 2, CF 3, CF N) are negative $1050 (negative because it is being paid out) Number of payments (N) is 30 years times 12 = 360 monthly payments Initial Investment is $200,000 IRR is 4.8% divided by 12 (to equate to monthly payments) = 0.400%

'Modified Internal Rate Of Return - MIRR' While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project. For example, say a two-year project with an initial outlay of $195 and a cost of capital of 12%, will return $121 in the first year and $131 in the second year. To find the IRR of the project so that the net present value (NPV) = 0: NPV = 0 = -195 + 121/(1+ IRR) + 131/(1 + IRR)2 NPV = 0 when IRR = 18.66% To calculate the MIRR of the project, we have to assume that the positive cash flows will be reinvested at the 12% cost of capital. So the future value of the positive cash flows is computed as: $121(1.12) + $131 = $266.52 = Future Value of positive cash flows at t = 2 Now you divide the future value of the cash flows by the present value of the initial outlay, which was $195, and find the geometric return for 2 periods. =sqrt($266.52/195) -1 = 16.91% MIRR You can see here that the 16.91% MIRR is materially lower than the IRR of 18.66%. In this case, the IRR gives a too optimistic picture of the potential of the project, while the MIRR gives a more realistic evaluation of the project.