Investment appraisal under

conditions of continuous and

discrete cash ows and
discounting
Tariq Ismail
Faculty of Commerce, Cairo University, Cairo, Egypt, and
Melinda Cline
Information Technology and Decision Sciences Department, University of North
Texas, Denton, Texas, USA
Abstract
Purpose This research furthers scholarly discourse which discusses the most effective way(s) to
calculate investment returns under conditions of continuous and/or discrete cash ows with
continuous and/or discrete discounting.
Design/methodology/approach Discusses Pogues work on the methods for investment
analysis.
Findings Pogues article of discrete versus continuous calculation of investment returns discusses
limitations of the traditional assumption that cash ows in investment appraisal occur at the end of
each period and points to a more realistic assumption that cash ows occur on a continuous basis.
Pogue then proposes a formula for managers to use when calculating investment returns. Finds that
Pogues suggested method of calculation is neither supported by prior literature nor sound in its
implications.
Originality/value Provides further analysis of discrete and continuous discounting models in
investment decisions.
Keywords Investment appraisal, Cash ow, Discounted cash ow
Paper type Literature review
Introduction
Pogues recent article of discrete versus continuous calculation of investment returns
(Pogue, 2004) discusses limitations of the traditional assumption that cash ows in
investment appraisal occur at the end of each period and points to a more realistic
assumption that cash ows occur on a continuous basis. Pogue then proposes a
formula for managers to use when calculating investment returns. While this is an
important area of research, Pogues suggested method of calculation is neither
supported by prior literature nor sound in its implications.
Continuous and discrete cash ows and discounts
When evaluating the present value of cash ow, two considerations are important.
These are the type of cash ows and the method of discounting. Cash ows may be
continuous over time or it may occur at discrete instances in time. Likewise,
discounting may be continuous throughout a given period or occur at discrete
intervals. Combining these two considerations, the present value analysis of cash ows
may then be divided into four categories:
The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at
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MAJ
20,1
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Managerial Auditing Journal
Vol. 20 No. 1, 2005
pp. 30-35
qEmerald Group Publishing Limited
0268-6902
DOI 10.1108/02686900510570678
(1) Discrete cash ows with discrete discounting.
(2) Discrete cash ows with continuous discounting.
(3) Continuous cash ows with discrete discounting.
(4) Continuous cash ows with continuous discounting.
Traditional models of discounting (net present value, internal rate of return) assume
discrete cash ows with discrete discounting. This assumption is made primarily to
simplify computations. However, in practice, project cash ows often do not occur
conveniently at the end of each period but rather occur on a continuous basis. Ismail
(1993) has surveyed the largest 250 UK quoted businesses on the question of
continuous returns. The study examines:
.
whether companies consider differences among continuous and discrete models
of discounting; and
.
how the use of an inappropriate discounting model affects investment decision
outcome.
The results indicate that 88 percent of companies having projects with continuous cash
ow applied ill-tting discrete discounting models and that this misapplication lead to
incorrect decisions being made on a signicant scale. The study also found that the
majority of decision makers would support continuous models and they are able to
recognize the aw of using the traditional discrete models. Unfortunately, managers do
not have a simple, understandable method to compute continuous investment returns
and discounts. The purpose of this paper is to review the prior literature on this topic,
point out the weaknesses of Pogues assumptions and methods, and further the
scholarly discussion of investment analysis methods.
Discussion of prior literature and the weaknesses of Pogues (2004) model
While it is important to develop a computationally simplistic method to compute
present value based on continuous discounting of continuous cash ows, Pogues
model is neither new nor sound. The prior research stream reveals important
considerations related to Pogues assumptions, formula, and analysis. Among these
studies are Grant and Ireson (1960), De La Mare (1975), Levy and Sarnat (1978), Wilkes
(1983), and Ismail (1994) who applied the integration method, Remer et al. (1984) who
used numerical methods, and Buck and Hill (1971) who applied the Laplace
transformation method. Table I shows the mathematical formulae used in previous
studies to compute present value of continuous cash ows.
In addition to not providing new insight, Pogues model fallaciously uses
continuous discounting in the belief that it represents continuous cash ows. Pogues
model suffers from the shortcomings of Levy and Sarnat model, as the model deals
only with continuous discounting and does not takes into account the nature of
continuity of the cash ows. The general form of Pouges model is as follows:
PV
_
t
0
edt 1
Referring to equation (1), it will be noted that cash ow is still only assumed to occur as
an end-of-period lump sum. Further extension of Pouges model is required to take into
Investment
appraisal
31
consideration the continuity nature of the cash ows. An examination of the way in
which the continuous discounting formula is derived shows, however, that it does
feature continuous discounting but without the treatment of continuous cash ows.
The Appendix shows the derivation of the present value of continuous cash ows
based on continuous discounting using Pouges formula, using calculus for its
derivation, this is:
PV
e
r
21
re
rt
2
Study Present value Comments
Grant and Ireson
(1960)
e
r
21
re
rn
The model is based on nominal rates
rather than effective rates of interest.
It should use effective interest rates
when continuous discounting is applied
De La Mare (1975) 1
1r
_ _
n
2
1
1r
_ _
n21
log
e
1
1r
_ _
The model is based on effective rates of
interest. It appears complex and this
may hamper its widespread use.
Therefore, a more simplied version of
the model is required
Buck and Hill
(1971)
1
r
2
_ _
e
2Lr
2e
2Mr
_

1
r
_ _
L 2Se
2Lr
2M 2Se
2Mr
_
The model is a special model rather
than a general model of discounting.
It deals with a pattern of cash ows
that increases with a constant
percentage over time (ramp cash ows)
Levy and Sarnat
(1978)
_
n
0
s
t
e
2kt
dt
The model assumes continuous cash
ows but takes into account only
continuous discounting. The cash
ows are integrated as a lump sum at
the end of each period
Wilkes (1983) 1 2e
2r
r
e
2n21r
The model is based on nominal rates
rather than effective rates of interest.
This may lead to incorrect decisions.
Remer et al. (1984) Ae
rn
21
re
rn
The model deals only with annuity
cash ows and needs further extension
to deal with other patterns of cash
ows
Ismail (1994)
r
log
e
1 r
n
The model can easily transform end of
year discount factors into continuous
discounting factors of continuous cash
ows. The model deals with effective
interest rates rather than nominal
interest rates
Notes: e the base for natural logarithms (2.71828); r interest rate; n time; L starting-point of
realizing cash ow in period L; M ending point of realizing cash ow at the end of period M;
S a point of time; S
t
cash ow invested in period (t); k continuous discount rate; dt interval
period of time; A annuity cash ows
Table I.
Present value formulae
used to compute
continuous discounting of
continuous cash ows
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It is clear that the derived model looks like Grants and Iresons model and is based on
the nominal interest rates rather than the effective interest rates. The effective interest
rates are recommended in discounted cash ow models based on continuous
discounting of continuous cash ows; as these rates gives a more realistic picture of the
productivity of an investment than the nominal rates. Therefore, further extension of
the derivation process is required to deal with effective interest rates to help user to
incorporate conventional interest tables such as found in standard textbooks on the
mathematics of nance with the newly developed models.
Ismail (1994) simplies the calculation of NPV/IRR models based on continuous
discounting factors by deriving a formula based on implicit differentiation (Lhopital
rule). This formula satises the business needs of a simple model of discounting, easy
to understand, applicable, deals with continuous cash ows, based on effective interest
rates, and overcome the aws of currently used models. The derived formula that
represents the present value of 1 realized continuously over time is:
Continuous discounting factor
r
log
1r
e
1 r
n
3
The simplest computational form for continuous discounting factors can be achieved
by separating formula (3) into two discounting components as follows:
Continuous discounting factor
r
log
1r
e
_ _
*
1
1 r
n
_ _
4
The rst component in formula (4) is a bias factor for correcting end of year
discounting factors into continuous cash ow discount factors, whereas the second
component is the present value of 1 received at the end of year (n) according to the
traditional present value tables of discrete discounting. So, the present value of
continuous cash ows can be obtained by multiplying the conventional end of year
discount factor, by the bias factor (interested readers may contact the authors to have a
more comprehensive list of this bias factor).
Furthermore, Pogue compares continuous and discrete discounting factors and
concludes that:
.
the difference between the two discounting factors increases as the interest rate
increases, thereby increasing the divergence between the present values of net
cash ow;
.
the difference between the two factors decreases as time increases and even
reverses at higher rates in more distant periods; and
.
the NPV/IRR based on continuous discounting is higher than NPV/IRR based on
traditional discrete discounting.
Unfortunately, Pogue oversimplies the comparisons between continuous and
discrete discounting factors and his examples were based on different interest rates
and using a time span of ve years. In fact, such illustration should take into account
the pattern of cash ow, as this will change Pogues conclusions. Ismail (1994) has
investigated the relationship between continuous and discrete discounting factors
in-depth and arrived at the conclusion that the present value model is a function of
the following variables:
Investment
appraisal
33
.
the investment life;
.
the discount rate; and
.
the cash ow pattern.
Therefore, the bias factor in formula (4) will not necessarily lead to real NPV (based on
continuous discounting) being higher than traditional NPV (based on discrete
discounting). The analysis supports that the relationship between continuous and
discrete models of discounting is unbounded in one direction; i.e. the continuous NPV/IRR
may be equal, lower than, or higher than the traditional NPV/IRR. This relationship
depends heavily on the temporal patterns of cash ows (level pattern of cash ows,
increasing pattern of cash ows, decreasing pattern of cash ows). However, the degree
of possible difference between the real and traditional NPV/IRR is greater when net cash
ows decrease overtime, investment lives are short, and the discount factor is high.
Ismails results are supported by the interesting gures shown in Table I in Pogues
article; where the percentage difference between continuous and discrete discount factors
is negative under a discount rate of 25 percent and time span of ve years.
Conclusion
In conclusion, the NPV/IRR of investment analysis is not necessarily higher when cash
ows are realized continuously and discounting is performed continuously during the
year. However, the difference in results between appropriately applied discrete and
continuous discounting models does inuence the soundness of investment decisions.
Management may accept/reject investment projects that should be rejected/accepted
when ill tting discounting models that do not take into consideration the nature and
pattern of the cash ows are applied. This continues to be an important topic of
research.
References
Buck, J.R. and Hill, T.W. (1971), Laplace transforms for the economic analysis of deterministic
problems in engineering, Engineering Economist, Vol. 16 No. 4, pp. 247-63.
De La Mare, R.F. (1975), An investigation into the discounting formulae used in capital
budgeting models, Journal of Business Finance and Accounting, Vol. 2 No. 3, pp. 203-16.
Grant, E. and Ireson, W. (1960), Principles of Engineering Economics, Ronald Press, New York,
NY.
Ismail, T. (1993), A UK study on assumed cash ow conditions and the application of the
traditional discounting cash ow model, working paper, Department of Accounting and
Finance, University of Birmingham, Birmingham, April.
Ismail, T. (1994), The renement of discounted cash ow techniques, unpublished doctoral
thesis, Department of Accounting, Faculty of Commerce, Cairo University, Cairo.
Levy, H. and Sarnat, M. (1978), Capital Investments and Financial Decisions, Prentice-Hall,
Englewood Cliffs, NJ.
Pogue, M. (2004), Investment appraisal: a new approach, Managerial Auditing Journal, Vol. 19
No. 4, pp. 565-9.
Remer, D. et al. (1984), The state-of-the-art of present worth analysis of cash ow distribution,
Engineering Costs and Production Economics, Vol. 7 No. 4, pp. 257-78.
Wilkes, F.M. (1983), Capital Budgeting Techniques, Wiley, Chichester.
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Appendix
Mathematical derivation of discounting factors based on continuous cash ows and continuous
discounting according to Pogue formula is:
PV
_
t
0
e
2rn
dt
2
1
r
e
2rn
_ _
t
t21
2
1
r
e
2rt
2e
2rt21
_
2
1
r
e
2rt
1 2e
r

_
2
1
r
e
2rt
e
r
21
_

e
r
21
re
rt
:
Investment
appraisal
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