The current worth of a future sum of money or stream of cash flows given a

The current worth of a future sum of money or stream

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The current worth of a future sum of money or stream of cash flows given a specified rate of return. To compute the PV of money you’ll receive some years from now, a discount rate is applied PV = FV/(1+r) n If someone offered you $500 today or $1000 in ten years, and inflation is 3%, which would you take? What if inflation rate is 1%? Or 8%? Future cash flows are discounted at the discount rate : - Reflects time value of money, risk or uncertainty of future cash flows - More uncertainty of cash flows: the higher the discount rate and lower the PV of future cash flows
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DCF Concept: Future Value Future Value : The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. Most common application of is compounding: The Future Value of money you have today at an interest rate FV = PV x (1+r) n (r = interest rate, n = # periods) Exampl e: $1000 invested today, Interest rate = 10%, Time = 5 years would have a Future Value of $1,611.00.
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FV PMT 1 2 3 4 n 0 Concept PV = $1000 5 years = $1611 r = 10%
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Compounding and Discounting The future value received in a year, from $1 invested today at 10%, is $1.10. The present value of $1.10 to be paid in a year when the interest rate is 10% is $1. With compounding, the future value received in 2 years, from $1 invested today at 10%, is $1.21 = 1 x 1.1 x 1.1. In reverse, the present value of $1.21 to be paid in two years when the interest rate is 10% is obtained by dividing the 1.21 by 1.1 2 .
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Uses You expect sales will grow so you will need more product. Is it better to build a plant or “rent” the capacity from someone else? You want to buy another company and merge it with yours. Will your increased profitability over time be worth the cost? What else could you do with the money? We’ve developed a new technology. It will take many years and a lot of money to bring to market. Will the expected future sales be worth the investment? Other examples?
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Formulas
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DCF Steps -> Figures of Merit Steps: 1. Estimate the relevant cash flows. 2. Calculate the rate of return for the investment. 3. Compare the returns to your acceptance criterion. But: 4. Step #1 is challenging. 5. Doing it well requires a thorough understanding of the company s markets, competitive position, and long-run intentions. 6. Potential estimation difficulties arise with depreciation, financing costs, working capital investments, shared resources, excess capacity, contingent opportunities, etc….
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Cash Flows for Container-Loading Pier ($M)
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Cash Flow Diagram for Container-Loading Pier
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Payback Period & Accounting Rate of Return, and Related Issues Concepts: Payback Period : Amount of time the company must wait before recouping its original investment. – The pier s payback period is 5 1/3 years ($40M / $7.5M).
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