**Time Value of Money Overview**

**Discounted cash flow analysis**

- It is a technique for evaluating the proposed investments to decide whether thy are financially worthwhile.
- The expected future cash flows (inflows/outflows) from the investment are all converted to a present value by discounting them at the cost of capital ‘r’
- Taking into account the concept of relevant cost.
- It is usually assumed that cash flow early during a year should be treated as a cash flow as at the end of the previous year.

**Present value Formulas**

**Discount factor = 1/(1+r)n**

where**r** = cost of capital**n** = number of periods

**Annuity factor = ( 1 – (1+r)-n /r)**

## Discounted Cash Flow

## Time Value of Money

- In Net present value (NPV) analysis, all future cash flows from a project are converted into a present value.
- NPV is the difference between present value of all costs incurred and present value of all benefits received.

**Approach**

- List all cash flows from the project (
*initial investments, future cash inflows/outflows*). - Discount these cash flows to present value using ‘cost of capital’ as discount rate.
- If present value of Benefits exceeds the present value of costs, the NPV is positive and if present value of benefits is less, then NPV is negative.

- A project is worthwhile if NPV is positive.
- The project commences at time ‘0’ where the cash flows are already at present value.
- Changes in working capital included as cash flows. An increase usually at the beginning of the project in time ‘0’ is a cash outflow and reduction is a cash inflow.

- It is the discounted rate of return on investment.
- It is the average annual investment return from the project.
- The NPV of the projected cash flows is ‘
**zero**‘ when those cash flows are discounted at IRR. - A company might establish the minimum rate of return that it wants to earn on an investment:

- If a project’s IRR is equal or higher than minimum acceptable rate of return, it should be undertaken.
- If IRR is lower than the minimum required return, it should be rejected.

- The following step are involved for calculation of a reliable Internal rate of return (IRR):

- Calculate NPV of the project at
**TWO**different rates. One of the NPV should be positive and the other should be negative. - Put the NPVs in the formula:

- Calculate NPV of the project at

## Discounted Cash Flow and Inflation

## Time Value of Money

- The cash flows expressed in today’s price terms.
- They ignore the expectations of inflation.
- In order to incorporate real cash flows in NPV calculation, real cash flows should be discounted at the real cost of capital.

The following steps are involved:

- Calculate real discount rate

**= money cost of capital – 1****inflation rate**

- Calculate net cash flows at today’s prices.
- Discount them using real discount rate.

**This is the most common method used.**

- Money (nominal) cash flows are cash flows that include expected inflation.
- Money cash flows should be discounted at the money cost of capital.

The following steps are involved:

- Calculate net cash flows at today’s price.
- Make adjustment for inflation (by doing this they will be converted into money cash flows).
- Use money cost of capital as discount rate.

***Both approaches give same solution, with a difference of rounding off.**

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