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Copyright: M. S. Humayun Financial Management Lecture No. 6 Present Value & Discounting

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Copyright: M. S. Humayun Present Value Objective is to calculate what is the Present Value from Future Cash Flows. We choose the Present (Today) as the most convenient point in time where we compare all the Cash Flows taking place at various points in time. We must compare everything at the SAME point in time otherwise, we would neglect Time Value. For example, Rs 105 is more than Rs 100 BUT, Rs105 after 1 year is not necessarily more than Rs100 today ! We first have to first bring all cash flows to the Present, or Discount them, and then compare them.

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Copyright: M. S. Humayun Present Value, Opportunity Cost, and Bank Interest How can it be that Rs 105 tomorrow is less than Rs 100 today? To understand this, we need to look at the Interest Rate as an Opportunity Cost. When you deposit your money in the bank and get interest, you are Sacrificing by (1) not consuming the money to buy something for yourself and (2) not investing your money somewhere where you can get a higher return than the bank interest. Almost everyone can deposit money in a bank savings account and get Bank Interest, so this is the minimum Opportunity Cost for anyone. Any business project, investment, or deal has to give a return better than the Bank Interest.

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Copyright: M. S. Humayun Interest Rates for Discounting Calculations Nominal (or APR) Interest Rate = i nom –Annual Nominal Interest Rate (quoted for 1 year) –Published in newspapers –Advertised by Credit Cards and Leasing Companies because it understates the actual (or Effective) interest you have to pay. Periodic Interest Rate = i per –Used in FM for Discounting and Present Value (PV) calculations –i per = ( i nom) / m where m = # of times compounding takes place in 1 year ie. If semi-annual compounding then m = 2 Effective Interest Rate = i eff –Used to compare securities and investments with different compounding cycles but not used for Discounting and PV. –i eff = (1 + ( i nom / m )) m – 1

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Copyright: M. S. Humayun Present Value (PV) Calculation Back to our original question: How can Rs 105 after 1 year be less than Rs 100 today? Answer: If the Periodic Interest Rate is say 10% per annum (p.a.), then we can use our old Interest Rate Formulas to solve what the PV of the future Rs 105 would be today. This is called Discounting the Future cash flow to the Present. –PV = FV / (1 + i ) n = 105 / (1+0.10) 1 = –Thus, the PV of Rs 105 (1 year from now) is Rs which is less than Rs 100.

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Copyright: M. S. Humayun Time & Arrow Diagram 1 Year Discounting of Future Value Time & Arrow Diagrams are important in visualizing the concept of Discounting Yr 0 Today Present Yr 1 Interest: 10% pa Time (Years) FV = Rs. 105 PV = Rs Discounting

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Copyright: M. S. Humayun Time & Arrow Diagram 2 Year Discounting of Future Value Notice how Discounting Rs 105 (FV2) from Year 2 gives a smaller Present Value (PV2 = Rs 87) than Discounting Rs 105 from Year 1 Yr 0 Today Present Yr 1 Interest: 10% pa Time (Years) FV1 = Rs. 105 PV1= Rs Discounting Yr 2 FV2 = Rs. 105 Interest: 10% pa PV2= Rs 87

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Copyright: M. S. Humayun Discounting Cash Flows of a Business, Investment, or Project Remember that the Value of a running business is based on the power of its assets to Generate Cash Flows. You can Forecast future Cash Flows of any Business, Investment, or Project based on: –Percent of Sales Method: simple & common –Cash Budget Method: more detailed

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Copyright: M. S. Humayun Discounting Cash Flows Cafe Case Study Suppose you are thinking about starting a small café or canteen inside a university campus. You make a simple Feasibility Report showing the Estimated Initial Investment and the Forecasted Cash Flows for the first Year (based on expected Cash Receipts from sales and Cash Payments for expenses). The Key Financial Data is as follows: –Initial Investment = Rs 100,000 –Forecasted Cash Receipts (end Year 1) = Rs 200,000 –Forecasted Cash Payments (end Year 1) = Rs 50,000 –Forecasted Future Investment (end Year 1)=Rs30,000 –Periodic Interest Rate (Opportunity Cost) = 10% p.a.

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Copyright: M. S. Humayun Cash Flow Diagram Café Example Yr 1 Interest: 10% pa Receipts = Rs. 200,000 Yr 0 Payments = Rs 50,000 Future Investment = Rs 30,000 Initial Investment = Rs 100,000 Use Downward Pointing Arrows to show Cash Outflows (Cash Payments or Investments). Use Upward Pointing Arrows to show Cash Inflows (Cash Receipts)

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Copyright: M. S. Humayun Simplified Cash Flow Diagram Café Example Yr 1 Interest: 10% pa Net Cash Receipts = CF1 = FV1 =200,000–50,000–30,000 = Rs 120,000 Yr 0 Initial Investment = Rs 100,000 After combining all Cash Flows for Year 2 into one Net Cash Flow Figure (CF1), you are ready to now Discount it to the Present…

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Copyright: M. S. Humayun Calculating the NPV of the Café Business for 1st Year NPV = NET Present Value (taking Investment outflows into account) NPV = - Initial Investment + Sum of Net Cash Flows from Each Future Year. NPV = - I o +PV(CF 1 )+ PV(CF 2 ) + PV(CF 3 )+ PV(CF 4 )+... Note that PV(CF 1 ) means the Present Value of Future Net Cash Flow (CF) taking place at the end of Year 1. CF is like the FV in our Interest Formulas. Our compounding cycle is 1 year so the Periodic Interest Rate is 10%. Present Value of Net Cash Flow from Year 1 = PV(CF 1 )= CF1 / (1+ i ) n = / (1+0.1) 1 = + Rs 109,000 Now to calculate the NET Present Value: NPV = - I o + PV(CF 1 ) = - 100, ,000 = + Rs 9,000 The NPV of our Business after 1 Year is Positive Rs 9,000 which is a good sign.

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