Quantitative Methods

Discounted Cash Flow Applications

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA
Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.
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Contents and Introduction

1. Introduction
2. Net Present Value Internal Rate of Return

Lecture 1
40 minutes

3. Portfolio Return Measurement

4. Money Market Yields

Lecture 2
16 minutes

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2. Net Present Value and Internal Rate of Return

Net present value and internal rate of return are often applied in all
fields of finance

Classic application is in capital budgeting where we make decisions on

how to allocate funds to long-term projects or investments

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2.1 NPV and NPV Rule

To understand the NPV concept let us consider a simple example: You invest $40 million today on a
project which is expected to return $10 million every year for 5 years. The appropriate discount rate is
5%. Should you go ahead?

What if you realize that the initial investment is actually $45 million?

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Practice Question 1
A project requires an initial outlay of $750,000. It is expected to produce
$200,000 in the first year, $300,000 in the second year, and $400,000 in
the third year. The cost of capital for this project is 10%. What is the NPV?
Should the project be accepted?

NPV = [CFt /(1+r)t]

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Compute NPV Using the Financial Calculator

A project requires an initial outlay of $750,000. It is expected to produce $200,000 in the first year,
$300,000 in the second year, and $400,000 in the third year. The cost of capital for this project is 10%.
What is the NPV? Should the project be accepted?
Keystrokes

Explanation

Display

[2nd] [QUIT]

Return to standard mode

[CF] [2nd] [CLR WRK]

Clear CF Register

CF = 0

750 [+/-] [ENTER]

Initial Outlay (in 000s)

CF0 = -750

[] 200 [ENTER]

Enter CF at T = 1

C01 = 200

[] [] 300 [ENTER]

Enter CF at T = 2

C02 = 300

[] [] 400 [ENTER]

Enter CF at T = 3

C03 = 400

[] [NPV] [10] [ENTER]

Enter discount rate

I = 10

[] [CPT]

Compute NPV

-19.722

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Steps for Calculating NPV

Identify all cash flows associated with the investment
Determine the appropriate discount rate or opportunity cost

Find the present value of each cash flow

Sum all present values
NPV = [CFt /(1+r)t]
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NPV Rule
Independent projects
If NPV is positive Accept
If the NPV is negative Reject

Mutually exclusive projects

Accept project with higher NPV as long as NPV is positive

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2.2 IRR and IRR Rule

Internal rate of return (IRR) is the discount rate that makes net present value equal to zero.

Say you invest $100 today and get $110 after one year. What is the IRR?

Invest $100 today. Get $10 at t = 1 and $110 at t = 2. What is the IRR?

NPV
= CF0 + [CF1/(1+IRR)1] + [CF2/(1+IRR)2] + + [CFN/(1+IRR)N] = 0
.
Internal because it depends only on the cash flows of the investment. It gives a sense for the return on
the project.
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Practice Question 2
Arnold Corp wants to estimate the IRR for a proposed project. The initial investment is
$150,000. Estimated cash flows for the following 3 years are $50,000 $100,000 and
$40,000 respectively. What is the IRR?

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Compute IRR Using the Financial Calculator

Arnold Corp wants to estimate the IRR for a proposed project. The initial investment is
$150,000. Estimated cash flows for the following 3 years are $50,000 $100,000 and
$40,000 respectively. What is the IRR?
Keystrokes

Explanation

Display

[2nd] [QUIT]

Return to standard mode

[CF] [2nd] [CLR WRK]

Clear CF Register

CF = 0

150 [+/-] [ENTER]

Initial Outlay (in 000s)

CF0 = -150

[] 50 [ENTER]

Enter CF at T = 1

C01 = 50

[] [] 100 [ENTER]

Enter CF at T = 2

C02 = 100

[] [] 40 [ENTER]

Enter CF at T = 3

C03 = 40

[] [RR] [CPT]

Compute IRR

13.11%

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IRR Rule
Independent projects
If IRR > Opportunity Cost Accept
If IRR < Opportunity Cost Reject

Mutually exclusive projects

Accept project with higher IRR as long as IRR > opportunity cost

IRR uses the opportunity cost of capital as the hurdle rate

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Practice Problem 3
Bill is interested in a project which requires an investment of $1.5 million. The project shall pay
$200,000 per year in perpetuity. The first cash flow will be received 1 year from today. The cost of
capital is 8%. What is the IRR. Should Bill invest?

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2.3 Problems with the IRR Rule

The IRR and NPV rules give the same accept or reject decision when
projects are independent
Often projects are mutually exclusive and need to be ranked
The IRR and NPV rules might rank projects different when:
The size or scale of the project differs
Timing of the projects cash flows differs

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NPV and IRR of Mutually Exclusive Projects

Difference in size/scale
Project

Investment at t = 0

Cash flow at t = 1

IRR (%)

NPV at 10%

-100

120

20%

10

1,000

1,150

15%

45

Difference in timing of cash flow

Project

CF 0

CF 1

CF 2

CF 3

IRR (%)

NPV at 10%

-100

120

20%

10

-100

170

19%

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When there is a conflict, rank/select based on the NPV rule

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3. Portfolio Return Measurement

As an investor you need to measure portfolio returns
Holding Period Return (HPR)

Two types of portfolio return measurement tools:

1. Money Weighted Return (IRR)
2. Time Weighted Return
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3.1 Money Weighted Rate of Return

Money-weighted rate of return is effectively the IRR of the investment
Determine cash flows and then compute IRR
Example: Compute the money-weighted return for the following scenario:
Time

Outlay

$20.00 to purchase the first share

$22.50 to purchase the second share

Proceeds

Cash Flow

$0.50 dividend received on first share

$1.00 received ($0.50 x 2 shares) received
$47.00 received from selling 2 shares @
$23.50 per share

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3.2 Time Weighted Rate of Return

The time-weighted return measures the compound rate of growth of $1 initially invested in the
portfolio over a stated measurement period.
Example: Compute the time-weighted return for the following scenario:
Time

Outlay

$20.00 to purchase the first share

$22.50 to purchase the second share

Proceeds
$0.50 dividend received on first share

$1.00 received ($0.50 x 2 shares) received

$47.00 received from selling 2 shares @ $23.50 per share

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Time weighted Return

Dealing with inflows/outflows during year

Dealing with negative return

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TWRR - Methodology
0

1
10%

-5%

3
15%

4
-10%

5
-20%

6
+30%

7
+20%

8
0%

Price the portfolio immediately prior to any significant

addition or withdrawal of funds.
Break the overall evaluation period into sub-periods
based on the dates of cash inflows and outflows.
Calculate the holding period return on the portfolio for
each sub-period.
Link or compound holding period returns to obtain an
annual rate of return for the year (the time-weighted
rate of return for the year).
If the investment is for more than a year, take the
geometric mean of the annual returns to obtain the
time-weighted rate of return over that measurement
period.
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MWRR versus TWRR

Money-Weighted Rate of Return

Time-Weighted Rate of Return

Simply the IRR

Compound rate of growth of $1 initially invested in

the portfolio over a stated measurement period

Return depends on timing and amount of cash

flows

Return does NOT depend on timing and amount of

cash flows

Not an appropriate performance measure if

portfolio manager does not control timing and
amount of investment
Appropriate measure if portfolio manager has
control over timing and amount of investment

Appropriate performance measure if portfolio

manager does not control timing and amount of
investment

Not an appropriate measure if portfolio manager

has control over timing and amount of investment

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Practice Question 4
Mariah purchases a share worth $50 on January 1, 2011. She made a subsequent purchase on January
1, 2012 of a share worth $60. Each share paid a dividend of $3 at the end of the year. On January 1,
2013, she sold the two shares and collected $150. Compute the time weighted and money weighted
returns?

money weighted return is 28.60%

time weighted return is 27.98%

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4. Money Market Yields

Money market is the market for
short-term debt instruments
Some instruments require issuer to
pay amount borrowed + interest
T-Bills are pure discount instruments
and are quoted on a bank discount
basis
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Different Yield Measures

Bank Discount Yield
Holding Period Yield

Money Market Yield

Effective Annual Yield
Bond Equivalent Yield
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Bank Discount Yield

BDY = D x 360
F
t
Where
D = Face value purchase value
F = Face value of the T-bill
t = Number of days remaining to maturity

Three issues
1. Interest not divided by investment amount
2. Simple interest
3. 360 day year
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Holding Period Yield

HPY = P1-P0 +D1
P0
Where
Po = initial purchase price of the instrument
P1= price received for the instrument at its maturity
D1= interest paid by the instrument at its maturity

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Money Market Yield (MMY)

MMY= HPY x 360
t
Where
HPY = Holding period yield
360 = Bank convention on number of days in a year
t
= Number of days till maturity

Two issues
1. Simple interest
2. 360 day year

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Effective Annual Yield (EAY)

EAY = (1 + HPY)365/t - 1

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Practice Question 5
A 90-day T-bill is purchased for $990. The face value is $1,000. Compute:
1)Bank discount yield

2)Holding period yield

3)Money market yield
4) Effective annual yield

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Practice Question 5 - Answers

Bank discount yield: [(1,000 990) / 1,000] x 4 = 0.04 = 4.00%
Holding period yield: (1,000 / 990) 1 = 0.0101 = 1.01%

Money market yield: 0.0101 (360 / 90) = 0.0404 = 4.04%

Effective annual yield: (1 + 0.0101 )365/90 1 = 0.04160 = 4.16%

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Yield Measure Conversions

MMY BDY

MMY EAY

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Yield Measure Conversions

BDY MMY

BDY EAY

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Bond Equivalent Yield

BEY is two times the semi-annual yield
Example: You purchase a bond for $1000. In return youll receive a $40
coupon every six months and the par value of $1,000 is returned at the
end of Year 4. What is the BEY?

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Summary
Net Present Value
Internal Rate of Return
Portfolio Return Measurement

Money Market Yields

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Conclusion
Review learning objectives
Examples and practice problems from the
curriculum
Practice questions from other sources

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