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Compounding
Discounting
One characteristic of all capital expenditure projects is that the cash flows
arise over the long term (a period usually greater than 12 months). Under this
situation it becomes necessary to carefully consider the time value of money.
Compounding (Compound Interest)
Interest is a payment to the investors of capital, for the use of the funds.
Compound interest is where interest generated in one period will earn
interest itself in future periods.
Exercise 1
$100 is invested in an account for five years. The interest rate is 10%
per annum. What is the value of the account after five years?
F = P.(1 + r) n
Where:
F = Future value
P = Initial investment (present value)
r = Interest rate (expressed as a decimal)
n = Number of time periods
Answer to Exercise 1
F = P.(1 + r) n
F = 100 x (1 + 0.10)5
Answer to Exercise 2
F = P.(1 + r) n
Compounding: F = P. (1+r)n
Discounting: P = F / (1+r)n
Exercise 1 - continued
P = F / (1+r)n
P = $161.05 / (1.10)5
P = $161.05 / 1.6105
P = $100
Discount Factors
Using Exercise 1
Present Value
PV = FV x DF
An annuity is a constant cash flow that occurs for ‘n’ periods or years.
Exercise 3
You will receive an annuity of $1,250 for the next three years. The
current discount rate is 10%. The first cash flow will be received in 1
years’ time.
Using PV tables:
NPV* 3,108
Exercise 4
You will receive a perpetuity of $2,000 starting one year from now. The
current discount rate is 10%.
PV Perpetuity = $CF x 1 / r
PV = $2,500 x 1 / 0.10
PV = $2,500 x 10
PV = $25,000
Delayed Annuity
i.e. the cash flow does not begin in the first year!!!...
Using PV tables:
NPV 4,564
The addition of the
individual DFs is
OR: - equal to the 2.535
CF$ DF 15% PV$ discount factor!!!...
YR3-7 1,800 2.535 4,563
OR Answer to Exercise – Jarvis Cocker Ltd
Advanced Annuity
An investment will generate cash flows of $1,800 each year beginning now
and for 4 further years. The discount rate is 15% per annum.
Using PV tables:
Compounding
Discounting