Essentials of Investment
Questions:
1. What is the discounted cash flow concept, and why is it essential for financial managers to understand and employ this important concept?
2. What are the methods associated with evaluating single or periodic payments, and what is at least 1 application of each?
3. Discuss the different methods that can be used to calculate these amounts, and explain how at least 1 of these models can be used?
4. How can the time value of money models or formulas be used to determine the rate of return for an investment or the time it will take for a current sum to grow to a desired future amount?
5. Discuss the "Rule of 72" and how it can be used to estimate how long it takes for money to double at various rates of return?
6. Identify and recommend at least 1 credible Web site that an investor can visit to find the current market value of market indexes such as the Dow Industrial Averages?
Answers:
1. Discounted cash flow concept is based on the time value of money and essentially arises since money received at an earlier date is dearer than money received at a later date. This is primarily because money has an opportunity cost and hence while evaluation of projects and various financial proposals it is imperative to consider the timing of the cash flows. It is imperative for financial managers to understand this concept so that they can make prudent financial decisions with regards to investing in projects and considering various proposals for the investment of idle cash reserves of the company. The prudent application of this concept would allow the financial managers to maximise the returns on capital for the company and hence ensure superior performance (Brealey, Myers and Allen, 2008).
2. The methods used for the evaluation of single or periodic payments are given below (Damodaran, 2008)..
1. Present value method – This involves the calculation of the present value of the various periodic payments assuming a reasonable opportunity cost usually risk free interest rate that the person assumes to earn. This can be used to estimate the present market price of a bond based on expected future coupon payments at periodic intervals..
2. Effective annual rate of interest - The effective annual rate of interest on the sum of money that would result in the periodic payments is also an evaluation technique. This can be used to estimate the YTM (Yield Till Maturity) of a given bond.
3. The various methods to determine this amount are given below (Kane and Marcus, 2013).
1. Annuity payment factor – In order to evaluate the present value of periodic payments, the annuity payment factor needs to be determined that acts as a discount factor. As a result, the present value of the annuity can be estimated by multiplying the payment in a particular period by the factor.
Hence, value of annuity = Annuity payment * Annuity payment factor
2. Cash flow discounting – Another method that may be helpful especially when the periodic payments are limited to a few periods is the actual discounting of the individual annuity payments using the given rate of interest.
4. In order to determine the rate of return of investment using the time value of money, the present value of the various cash flows derived during the lifetime of the investment must be equated with the current market value of the investment. This would result in the determination of the discount factor that would lead to the rate of return of investment (Damodaran, 2008).
Current price of investment = C1/(1+x) + C2/(1+x)2 + C3/(1+x)3 + ....... + Cn/(1+x)n
Where n is the rate of return of investment
Additionally, in order to determine the time for a particular investment to grow to a desired future amount, it is imperative to equal the future value of the current investment with the desired future value. On solving this, the time can be determined (Parrino and Kidwell, 2011).
Desired future value = Amount invested * (1+ r)t
Where t is the number of time periods and can be determined by using the above approach.
5. As per the “Rule of 72”, the time in years that is required to double the given principal in the case of compound interest is given by 72 divided by the underlying rate of interest. With regards to accuracy, this rule provides highly accurate results if the interest rate lies in the interval of 6-10%. This is a convenient tool to simplify calculations in case of compound interest. In order to estimate the time to double any given principal, input data regarding the underlying interest rate is required (Brealey, Myers and Allen, 2008). For instance if the interest rate ids 8% pa, hence the time required to double the principal or investment would be 72/8 = 9 years.
6. One website that an investor can visit to find the current market value of market indexes is www.bloomberg.com . This website is highly reliable and provides the latest information with regards to not only the US stock indices but also the other significant indices around the globe.
References
Brealey, R., Myers, S. and Allen, F. (2008), Principles of Corporate Finance, New York: McGraw Hill Publications Damodaran, A. (2008), Corporate Finance, London: Wiley Publications
Kane, B.Z. and Marcus, A.J. (2013). Essentials of Investment, Singapore, McGraw-Hill International Parrino, R. and Kidwell, D. (2011), Fundamentals of Corporate Finance, London, Wiley Publicationsa
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