LECTURE TWO

Discounting
Time Value of Money

The time value of money (TVM) is a fundamental financial concept that suggests
that money today is worth more than the same amount of money in the future
due to its potential earning capacity. This principle is based on the idea that money
has the potential to earn interest or generate returns over time, so it is more valuable
in the present than in the future.

Why?
1. Opportunity cost: If you have money today, you can invest it and earn a return
2. Interest: ability to earn interest or returns on money means that receiving
money now is more beneficial than receiving it later
3. Inflation: Over time, inflation erodes the purchasing power of money. So, a
fixed amount of money in the future may not buy as much as it would today
4. Risk: There is often more uncertainty or risk associated with future cash flows.
The further in the future a payment is, the greater the risk that it may not be
received.

Discounting: process of converting future value of money to its present value to

allow us to compare present value of different present and future payments

Formulas:

 PV = Present Value
 FV = Future Value
 r = Interest rate (or discount rate  opportunity cost of capital)
 n = Number of periods

why opportunity cost of capital?

Its is the return that is foregone by investing in the project rather than investing in
financial markets.

Annual and effective interest rates

APR (Annual Percentage Rate):

  Definition: APR is the interest rate charged or earned on a loan or investment
over a one-year period, without taking into account compounding within that
year. It is the nominal rate, and it includes only the interest cost and any other
fees associated with the loan or investment.
 Key Points:
o It does not include the effects of compounding.
o APR is primarily used for loans, mortgages, credit cards, and other
types of credit.
o It is expressed as a yearly rate, and it is often used to help consumers
compare different credit products.
o For example, if a loan has an APR of 10%, it means you’ll pay 10% of
the principal amount as interest over the year, excluding compounding
effects.

EPR (Effective Percentage Rate):

 Definition: EPR, often referred to as EAR (Effective Annual Rate), takes

into account the effects of compounding. It represents the true cost of
borrowing or the true return on an investment over one year.
 Key Points:
o It includes the effects of compounding, meaning it reflects how interest
accumulates more frequently than annually (e.g., monthly, quarterly).
o EPR is more accurate when comparing investments or loans that
compound interest at different intervals.
o The formula to calculate EPR is:

Annuity
A financial product that provides a series of payments made at equal intervals over
time. It is commonly used for retirement income, insurance payouts, or structured
settlements LOANS.

The present value of an annuity is:

To find the amount of payment given at present value:
Annuity with growth
Cash flow of an annuity is received which from then on grows by g every year until
t=T with the discount rate r.

A problem

 You are 30 years old and want $2 million at age 65.

 You contribute annually, but the amount you contribute grows by 5% per year.
 The investment grows at an 8% return per year.
 We need to find the initial savings amount (A), which grows each year.

Step 1: Present Value of the Target Amount

At age 65, you want $2,000,000. Since the money is growing at an interest rate of
8% per year, we discount it back 35 years (from age 65 to 30) using the formula:

This gives the present value of the target (future) amount in today's terms.
Step 2: Solve for A

Problem:
Suppose you plan to save $6,500 in the first year, increasing your savings by 5%
each year for 35 years. At the end of 35 years, your savings should grow to
$2,000,000. What annual return rate r must your investments earn to reach this
goal?
Perpetuity
This is an annuity which does not expire for example: Endowments & trust funds that
need to provide payments indefinitely.
Life insurance is also one.
Winning a lottery

Endowments & trust funds that need to provide payments indefinitely.

Perpetuity with growth

In a perpetuity with growth, A is the first cash flow one period from now which
increases annually at rate g, r is the discount rate
Mortgage calculation examples

Step 1: Understanding the Loan

 House Price: $500,000

 Down Payment: $100,000
 Loan Amount (Principal): 500,000−100,000=400
 Annual Percentage Rate (APR): 8.5% (compounded monthly)
 Loan Term: 30 years
 Total Payments: 30×12=360 months
 Capital Budgeting

Net Present Value

Net Present Value (NPV) is a financial metric used to evaluate the profitability of an
investment or project. It calculates the present value of future cash flows by
discounting them at a given rate and subtracting the initial investment.

Example:

Interpreting NPV

 NPV > 0 → The project adds value and is profitable.

 NPV < 0 → The project destroys value and should be rejected.
 NPV = 0 → The project breaks even (investors just earn the required return).

Investment Criteria

1. For a single project, take it if NVP is positive

2. For many independent projects, take all those who with a positive NVP
3. For mutually exclusive projects, take the one with the positive and highest
NVP
Cash Flow Calculations in Capital Budgeting

When evaluating a project, we focus on cash flows rather than accounting earnings
because cash flows represent actual money moving in and out of the business, while
accounting earnings include non-cash items (like depreciation) that do not affect
liquidity. Here’s how to correctly calculate project cash flows:

1. Use Cash Flows, Not Accounting Earnings

 Why? Accounting earnings include non-cash expenses (e.g., depreciation)

and accruals, which do not reflect the actual cash available to the firm.
 Example: Suppose a company has net income of $100,000 but includes
$20,000 in depreciation expense. The actual cash flow is:

2. Use After-Tax Cash Flows

 Why? Taxes reduce the amount of cash the company keeps, so we must
consider cash flows after taxes to get a realistic estimate.
 Formula:

3. Use Cash Flows Attributable to the Project (Incremental Cash Flows)

This means we compare the firm’s value with and without the project to determine
the additional cash flows generated by the project.

 Include only incremental cash flows (cash flows that occur because of the
project).
 Ignore costs that would be incurred anyway (sunk costs).

A company is considering launching a new product:

 Expected revenue from the new product: $500,000 per year

 Existing product sales drop by $100,000 per year (cannibalization effect)
 Additional costs to produce new product: $250,000 per year
 Net incremental cash flow:

500,000−100,000−250,000=150,000 per year500,000 - 100,000 - 250,000 =

150,000 \text{ per year}500,000−100,000−250,000=150,000 per year

Only the net impact on cash flow is relevant.

4. Ignore Sunk Costs

  Sunk costs are past costs that cannot be recovered and should not influence
the decision.
 Example: If a company spent $50,000 on market research last year for a
potential project, this cost should be ignored because it does not affect
future cash flows.

5. Include Investment in Working Capital as Capital Expenditure

 Projects often require an investment in working capital (cash tied up in

inventory, receivables, etc.).
 Example:
o To support a new project, the company must increase inventory by
$20,000 and increase accounts receivable by $30,000.
o Even though this is not a direct cash outflow like buying equipment, it
still reduces available cash and must be included.
o Later, when the project ends, working capital may be recovered.
Payback Period
The time it takes for a project to breakeven

For independent projects: Accept the project is the number of years is less than or
equal to some threshold t*
For mutually exclusive projects: Amount all the project where the number of years is
less than or equal to some threshold , accept the one that has a minimum payback
period

Shortfalls:
1. Ignores cashflows after t*
2. Ignores discounting
Discounted Payback period
Discounts future cash flows to present value before summing them. Still looking for
the time it takes for an investment to recover its initial costs

 still ignores cash flows after the discounted payback period

Steps:
1. Discount each year’s cash flow to its present value
2. Sum the discounted cash flows year by year to find the cumulative
value
3. See if the sum is above or below the initial investment value

Internal Rate of Return (IRR)

It represents the discount rate at which the Net Present Value (NPV) of a project’s
cash flows equals zero. In other words, the IRR is the rate at which the present value
of cash inflows equals the initial investment, indicating the break-even point for the
project in terms of its returns.

How IRR Works:

 IRR is the rate that makes NPV = 0.

 It is often interpreted as the annualized effective compounded return on an
investment.

Rules:

 If the IRR is greater than the required rate of return (or cost of capital), the
project is considered a good investment.
 If the IRR is less than the required rate of return, the project should generally
be rejected.

To solve, set (1 + IRR) = x and then solve for x

IRR shortfalls
Lending or borrowing
 IRR is not always a reliable decision rule—you must also check whether the
project involves lending or borrowing and compare IRR against the
opportunity cost of capital accordingly.

1. Project A (Typical Investment Project)

o You pay $1,000 upfront and receive $1,500 later.
o This is like lending money at an IRR of 50%.
o A higher IRR is better because you want a high return when lending.
2. Project B (Borrowing Scenario)
o You receive $1,000 upfront and repay $1,500 later.
o This is like borrowing money at an IRR of 50%.
o A lower IRR is better because you want to borrow at the lowest rate
possible.

Why IRR Alone Can Be Misleading

  In Project A, NPV decreases as the discount rate increases (as expected).
 In Project B, NPV increases as the discount rate increases—opposite of
typical investments.
 The IRR rule (accept if IRR > cost of capital) fails for Project B because we
want a lower borrowing rate, not a higher one.

Multiple IRRS
 When a project’s cash flow changes sign more than once (e.g., initial
investment → positive cash flows → large end cost), it can have multiple
IRRs.
 These IRRs occur because the NPV curve first increases, then decreases
as the discount rate rises.
 If cash flows switch signs more than once, the NPV curve can cross zero
multiple times, creating multiple IRRs.
 Having two IRRs makes it unclear which one to compare to the cost of
capital.
 There are cases where no IRR exists (if NPV is always positive or negative).
 Example: Project C has cash flows (+1,000, -3,000, +2,500) and no IRR, but
always has a positive NPV, meaning it's a good investment.

 solution: look at NVP instead

Ranking a project using IRR for mutually exclusive projects

IRR can mislead when comparing projects of different sizes or cash flow patterns.
Always use NPV, or at least compare the IRR of incremental cash flows.

IRR Can Be Misleading for Mutually Exclusive Projects

 When choosing between projects of different sizes or cash flow patterns,

IRR may not indicate the best decision.
 Example:
o Project D (IRR = 100%, NPV = $8,182)
o Project E (IRR = 75%, NPV = $11,818)
o IRR suggests choosing D, but E has a higher NPV and is actually the
better investment.

Using Incremental IRR to Correct This

 Compare the incremental investment (E - D):

o Extra investment: -$10,000
o Extra return: +$15,000
o IRR on incremental investment = 50% (greater than cost of capital)
 Since the incremental return is above the opportunity cost of capital (10%),
E is better than D.

Projects with Different Cash Flow Timings

 Example:
o Project F (short-term, high IRR = 33%, NPV = $3,592)
o Project G (long-term, lower IRR = 20%, but higher NPV = $9,000)
Profitability index

The ratio of present value of future cash flows and the initial cost of Capital of a
project

Rules:
- For independent projects accepts all where PI is greater than 1
- Mutually exclusive projects: amount projects with PI greater than 1, accept the
highest one

Shortfalls:
PI gives the same answer as NPV when:
- There is only one cash outflow, which is at time 0
- Only one project is under consideration.

PI scales projects by their initial investments. The scaling can lead to wrong answers
in
comparing mutually exclusive projects.