MGMT_130_Lecture_5

# MGMT_130_Lecture_5 - MGMT 130 Lecture 5 Discounted Cash...

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MGMT 130 Lecture 5 Discounted Cash Flow Valuation

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Future Value and Present Value Present Value is a key concept in finance. A dollar today is worth (generally) more than a dollar tomorrow. Why? The Future Value of a dollar is the amount of money that you could have if you invested that dollar at the risk-free interest rate. The Present Value of a future sum is the amount of money that you would need, today, to invest at the risk-free rate in order to receive that future sum tomorrow. FV = C x (1+r) or FV = PV x (1+r) So, PV = C / (1+r)
Present Value PV = C/(1+r) So, the present value is the discounted value of the future cash flow. The interest rate, r, is also called the discount rate. It discounts future cash flows for the time value of money. As we will see later, the discount rate can also discount future cash flows to compensate for the riskiness of those cash flows. In this case, r will not be the simple interest rate.

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Principle of Indifference Suppose the risk-free interest rate is 10%. I offer you \$10,000 right now or \$11,000 in one year. Which do you prefer? You should be indifferent between the two. (Note: assumes equal borrowing and lending rates and unlimited credit markets!) What if you are a developer building an apartment complex in one year. The value of the apartment complex is subject to a lot of uncertain outcomes. We will need to use a discount rate greater than the risk-free interest rate to discount these cash flows. You will not be indifferent between a risk-free dollar and an uncertain payment of the same
Net Present Value The Net Present Value (NPV) takes into account all costs (present and future) and payments and discounts them back to the present day. We can then determine if this stream of cash flows has a positive or negative Net Present Value. NPV = – Cost + PV

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We can buy an empty parking lot for \$100,000 and pay \$200,000 to build an apartment building on the lot. We can then sell the apartment complex on the open market for \$350,000. (Let’s assume this value is certain.) The risk-free interest rate is 12%. NPV = – 100,000 – 200,000 + 350,000 /
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## This note was uploaded on 04/25/2010 for the course MGMT 130A taught by Professor Stuff during the Winter '10 term at UCLA.

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MGMT_130_Lecture_5 - MGMT 130 Lecture 5 Discounted Cash...

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