Discounted Cash Flow Analysis

Finance

r

discount rate

IRR

rate of return (otherwise known as r) that makes the NPV equal to zero

Drawbacks of IRR

Non-unique IRR possible when CFs switch signs multiple times
Doesn’t adjust for scale or duration of project

As long as the first cash flow is negative and the rest are positive you are guaranteed an unique IRR

True

Perpetuity

a constant or constantly growing stream of cash flows that continue forever

Annuity

a level stream of cash flows for a fixed period of time

The cash flow principle

Because money has a time value, record investment cash flows when the money actually moves, not when the accountant using accrual concepts says they occur. And if the money doesn’t move, don’t count it.

The with-without principle

imagine two worlds, one in which the investment is made and one in which it is rejected. All cash flows that are different in these two worlds are relevant to the decision, and all those that are the same are irrelevant.

[EAR=(1+APR/m)^m]-1

APR = stated annual interest rate

M = number of compounding periods per year

A lower effective annual rate is better for borrowing

discount rate is below the IRR

NPV is positive

discount rate is equal to IRR

NPV is zero

discount rate is above the IRR

NPV is negative