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.
X= 12 times
Dirty power x^1/n
Make a factor then follow below steps
√ 12 times
Divide by power
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
Without taking factor of exponential rate follow below step.
x= 12 times
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.
It is reverse of present value.