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Lecture 2

Discounted cash flow & applications


Return measurements

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Discounted Cash Flow Applications

 Discounted cash flow (DCF) has numerous


applications including:
1) Valuing/Pricing securities (stock and bonds).
2) Determining if an investment is desirable (capital
budgeting).

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Calculate PV using Excel

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Calculate PV using Excel

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Net Present Value
 Net present value (NPV) is one of the important
application of the DCF concept.
 NPV is the difference between the present value of
cash inflows and the present value of cash outflows
over a period of time

 If NPV ≥ 0 we accept the project. If NPV < 0, we


reject the project.
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Example 2-1 Using NPV

RAD Corporation intends to invest $1 million in R&D


and expects incremental cash flows of $150,000 in
perpetuity from this investment. If the opportunity cost
of capital is 10%, will RAD Corp. invest in the project?

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Internal Rate of Return
 Assumption: Cash flows are reinvested at IRR.
 The internal rate of return on a project is the interest
rate that makes the NPV = 0.
 If IRR ≥ discount rate (opportunity cost of the
project), we accept the project.
CF1 CF2 CFN
NPV  CF0    ...  0
(1  IRR ) (1  IRR )
1 2
(1  IRR ) N

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Internal Rate of Return

INTERNAL RATE OF RETURN USING EXCEL'S RATE FUNCTION TO


Year Cash flow
COMPUTE THE IRR
0 -800
1 200 Initial investment 1,000
2 250
Periodic cash flow 100
3 300
Number of payments 30
4 350
5 400
<-- =RATE(B4,B3,-
IRR 9.307% B2)
Internal rate of return 22.16% <-- =IRR(B3:B8)

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Further issues: NPV&IRR
 Different size projects:
 Suppose one project €10,000; another one project
€30,000 to invest.

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Further issues: NPV&IRR
 Different Timing of Cash flows

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Further issues: multiple IRRs
Discount rate 6%
NPV -3.99<-- =NPV(B2,B7:B11)+B6

Year Cash flow


0 -145
1 100
2 100
3 100
4 100
5 -275

Two IRRs
5.00

0.00
0% 10% 20% 30% 40%

Net present value


-5.00

-10.00
Discount rate
-15.00

-20.00

-25.00

Identifying the two IRRs


First IRR 8.78%<-- =IRR(B6:B11,0)
Second IRR 26.65%<-- =IRR(B6:B11,0.3)
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Further issues: NPV &IRR

 Summary:
• If we are comparing different size projects,
the one with the highest IRR may not add
the greatest value to the firm.
• If the timing of cash flows differ.
• If the sign of the cash flows changes more
than once, we may get more than one IRR.

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Portfolio Return Measurements
• Portfolio is a collection of securities that one
invests in.
• The idea is to diversify the risk among different
securities.
• Suppose you want to assess the success of your
investments.
• Need to consider two related but distinct tasks:
– The first is performance measurement, which involves
calculating returns in a logical and consistent manner.
– The second is performance appraisal which is, the
evaluation of risk adjusted performance.

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Different measurements of Returns
(performance measurements)

 Holding
Period Return (HPR)
 Money-Weighted Rate of Return
(MWRR)
 Time-Weighted Rate of Return (TWRR)

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Holding Period Return
 HPR is the return that an investor earns by holding a
portfolio for a specific time period. P0 is initial
investment, P1 is the price received at the end of the
holding period.
P1  P0
HPR 
P0
 If the dividend D1 is paid by the investment at the
end of the holding period
P1  P0  D1
HPR 
P0
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Money-Weighted Rate of Return
(Similar idea as IRR)
• MWRR is the rate of return that accounts for
the timing and amount of all dollar flows into
and out of the portfolio.
• Solving the present value of cash outflows
equals to the present value of cash inflows:

PV(outflows) = PV(inflows)
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Example of MWRR

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Example Cont.
 By solving below equation

we will get MWRR = 9.39%


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Example Cont.
 What is HPR in this case?
 HPR in period 1:($225-$200+$5)/$200=15%
 HPR in period 2:($470-$450+$10)/$450=6.7%
 Mean HPR: (15%+6.7%)/2=10.84%.

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Time-Weighted Rate of Return

 The TWRR is the rate of return that is not


sensitive to additions and withdrawals.
• preferred performance measure in the
industry.
• it measures the compound rate of the growth
of $1 initially invested in the portfolio over
a stated measurement period.

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To compute TWRR on a portfolio, take the
following three steps:

1. Break the overall evaluation period into sub-periods based


on the dates of cash inflows and outflows.

2. Calculate the holding period return on the portfolio for


each sub-period.
MVE t  MVB t
rt 
MVB t

MVBt is the market value at the beginning of the period.


MVEt is the market value at the end of the period.

3. 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). 21
Example:TWRR
• Calculate the TWRR for the In-House a/c

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TWRR
 We can often obtain a reasonable approximation of
the time-weighted rate of return by valuing the
portfolio at frequent, regular intervals.
• The more frequent the valuation, the more accurate
the approximation.
• We compute 365 such daily return and link them
to get annual return.

rTW  [(1  r1 )  (1  r2 )  ...(1  r365 )]  1

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Annualized TWRR
 If the investment is for more than one year?

 We calculate an annualized time-weighted return as


the geometric mean of N annual returns, as follows:

rTW  (1  r1 )  (1  r2 )   (1  rN )
1/ N
1

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Annualized TWRR
 Suppose that the portfolio earned returns of 15
percent during the first year and 6.67 percent during
the second year, what is the portfolio’s time-weighted
rate of return over an evaluation period of two years?

Time - weighted return  (1.15)(1.0667)  1


 10.76%

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Money Market
 Money market is the market for short-term debt instrument
(one year maturity or less).
 A very good example of a short-term debt instrument is a
treasury bill. T-bills are pure discount instruments (pays no
income until maturity, whereupon the investor receives the
face value of the instrument . These instruments are issued at
a price lower than face value).
 T-bills are quoted on a bank discount basis, rather than on a
price basis.
D 360
rBD 
F t
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Bank discount yields

 Where, rBD = the annualized yield/return on a


bank discount basis
 D = the dollar discount, which is equal to the
difference between the face value of the bill F,
and its purchase price P0.
 F = the face value of the T-bill
 t = the actual number of days remaining to
maturity
 360 = bank convention of the number of days
in a year
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Example 2-6 Bank Discount Yield

 Suppose a T-bill with a face value of


$100,000 and 150 days until maturity is
selling for $98,000. What is the bank
discount yield?
D 360
rBD 
F t
($100,000  98,000) 360
  .048
$100,000 150
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Drawbacks of BDY
1. The yield is based on the face value of the
bond, not on its purchase price.
2. Returns from investment should be evaluated
relative to the amount that is invested.
3. The bank discount yield annualizes with
simple interest, which ignore the opportunity
to earn interest on interest (compound
interest).

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Holding Period Yield

 In fixed income markets, this holding period


return is also called a holding period yield
(HPY). P0 is the purchase price of the
instrument.P1 is the price received at its
maturity and D1 is the interest (cash
distribution) paid upon maturity.
P1  P0  D1
HPY 
P0
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Effective Annual Yield
 The effective annual yield (EAY) takes the
quantity 1 plus the holding period yield and
compounds it forward to one year, then
subtracts 1 to recover an annualized return that
accounts for the effect of interest-on-interest

EAY  (1  HPY) 365 / t


1

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Example Computing EAY
 Suppose an investment of $98,000 will pay
$100,000 in 150 days. What is the EAY?

HPY  (100,000  98,000 ) / 98,000  0.02048


EAY  (1  HPY ) 365 / t
1
 (1  0.02048 ) 365 /150  1
 0.050388 or 5.0388%

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Money Market Yield
 The money market yield convention makes the
quoted yield on a T-bill comparable to yield
quotations on interest-bearing money-market
instruments that pay interest on a 360-day
basis.

rMM  (HPY )(360 / t )

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Money Market Yield
 Find the money market yield for the T-bill in
Example 2-6.

$100 ,000  $98,000


HPY   .020408 or 2.0408%
98,000

rMM  ( HPY )(360 / t )


 (.020408 )(360 / 150 )
 .04898 or 4.898%

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