Concept of discounting
Present value of Rupees is in present term whereas future value of
rupees is in future term. In future value of rupees required rate of return is
included. To sacrifice the current consumption for certain period we would
require compensation for sacrificing current consumption it is known as
required rate of return.
The value of assets is the present value of
future cash flows discounted at the appropriate required rate of return.
In financial management we would take decision based on future cash flow
whereas investment will be at present so all the future cash flow discount are
required rate to bring in present term.
Intrinsic value = PV of the
future cash flow discounted at Re.
While discounting future cash flow would be
discounted with the rate applicable for that year, if rate is different of each
year, then successive cash flow would be discounted first with rate applicable
for previous year then finally rate applicable for such year. For example 3rd year cash flow would be
discounted first with the rate applicable for 1st year then 2nd year then finally with the discount rate of 3rd year.
Inflation
in capital budgeting
There should be consistency between Nature of
cash flow and discount rate. Nominal cash flow discount with nominal rate and
real cash flow discount with real rate, etc. if cash flow is ex inflation then
incorporate inflation in future cash flow in consecutive term. That to
incorporate inflation in cash of third year, inflation affect 1, 2 and 3rd year should be
incorporated.
While incorporating inflation in cash flow
successive cash flaw with accumulate inflation cumulatively. For example 3rd year cash will include
inflation of for 1st year then 2nd year then finally with the inflation rate of 3rd year.
Frequency
of compounding
Effective annual yield compounded
annually
Rate = (1+ rate)n-1
Money market yield
compounded n time in a year.
Holding Period yield
Bond equivalent yield
compounded half yearly.
Concept of continuous compounding (Exponential)
Rate
change in real time that is compounded every moment. Without taking factor of
exponential rate follow below step.
Step 1
|
(X).000244017206
|
Step 2
|
(+) 1
|
Step 3
|
X= 12
times
|
Dirty
power x^1/n
Make a factor then follow
below steps
Step 1
√ 12 times
Step 2
- 1
Step 3
Divide by power
Step 4
+ 1
Step 5
x= 12
times
Annuity and its application
Annuity is the sum of discounting factor. It is used to derive present
of future cash flow if all the cash flow is equal. It is also used to derive
equal future instalment of present value cash flow either by dividing with
annuity factor or multiplied with capital recovery factor.
Capital recovery factor =
1/ annuity factor,
Application of normal
distribution
# Ln
Without
taking factor of exponential rate follow below step.
Step 1
|
x= 12
times
|
Step 2
|
- 1
|
Step 3
|
÷ .000244017206
|
Perpetuity and its
application
It is used in case of no growth wherein a
certain cash flow is expected to continue for uncertain future period.
IV= A/i
Future value
It is reverse of present
value.
