Time Value of Money and Discounted Cash Flow Concepts

Ok, so I am personally using the TI Business Analyst II plus for the exam and will be using calculation methods for that particular calculator. The other permissible calculator at the exam is the HP 12 C. I personally do not use that calculator but those that are interested in using it can find a user’s guide online.

Now, let’s take a look at some of the important concepts regarding TVM:

Here are some of the important functions on the calculator that we would be using:

  1. N= No. of compounding periods
  2. I/Y= Interest rate per compounding period
  3. PV= Present Value
  4. FV= Future Value
  5. PMT = Annuity Payments or constant periodic cash flow
  6. CPT = Compute

Effective Annual Rate or EAR: [(1+periodic rate)^m] – 1 where periodic rate = Stated rate/m, m= no. of compounding periods

Semiannual: m = 2, Quarterly: m =4, Monthly: m=12 and daily : m=365

To solve present value, future value and annuity problems – it’s mostly plugging in available data into the calculator and computing for the required variable.

(Note: for annuity due problems make sure the calculator is in begin mode or perform calculation in end mode and multiply the answer by (1+ interest rate), to get the calculator into begin mode – 2ND [Begin] 2ND [SET] 2ND [QUIT])

Present Value of  a Perpetuity = PMT/ Interest rate

Compounding the FV and PV of uneven cash flows:

Steps:

  • Calculate individual present or future value given in the problem
  • Add them all

When compounding periods are other than annual:

  • Multiple the periods by the number of compounding periods
  • Divide the Interest rate by the number of compounding periods

Compounding period reference table;

  • Annual: 1
  • Semi-annual:2
  • Quarterly:3
  • Monthly:12
  • Daily:365

Discounted Cash Flow Concepts

Computing NPV with the Business Analyst II Plus:

  • Press Cash Flow (CF)
  • Hit 2ND and Clear Work (CE/C) to clear history
  • for CFo enter initial cash outlay (usually negative since it is an outflow so press the +/- button to enter negative value)
  • Hit Enter and press the down arrow twice
  • Then enter a value for CF1 and hit the down arrow key twice unless the same amount is required to be entered and you can enter the frequency for it.
  • After entering all values, press NPV enter the discount rate, hit enter, press the down arrow key and hit CPT

Computing IRR

  • Press Cash Flow (CF)
  • Hit 2ND and Clear Work (CE/C) to clear history
  • for CFo enter initial cash outlay (usually negative since it is an outflow so press the +/- button to enter negative value)
  • Hit Enter and press the down arrow twice
  • Then enter a value for CF1 and hit the down arrow key twice unless the same amount is required to be entered and you can enter the frequency for it.
  • After entering all values, hit IRR and then CPT

Some other NPV and IRR related concepts:

  • Accept Projects with positive NPV
  • For mutually exclusive projects, accept project with higher NPV
  • Accept Projects with IRR greater than the required rate of return
  • When IRR and NPV conflict in the decision making process, choose NPV

Bank Discount Yield: (D/F)x(360/t)

  • D= Face Value – Purchase Price
  • F = Face Value
  • t = number of days till maturity
  • 360= bank convention of number of days in a year

Holding Period Yield (HPY):

(P1-P0+D1)/(P0) = [(P1+D1)/P0] – 1

  • P0 = Initial price
  • P1= Price received at maturity
  • D1= Interest payment

Effective Annual Yield: [(1+HPY)^(365/t)] – 1

Money Market Yield: (360/t) x HPY or [(360 x Bank Yield)/(360-(t x Bank Yield)]

Bond Equivalent Yield – 2 x semi annual discount rate

  • Convert the yield into effective semiannual discount rate and then double it

Hope some of the summaries above help revising concepts. Leave comments.

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