Discounted Cash Flow Calculations

Net Present Value (NPV) & Internal Rate of Return (IRR)

Net Present Value (NPV)

NPV is the amount determined by discounting a potenial investments projected cash inflows at the rate of return required by the investor (Which can be either an individual or institution) and subtracting the original investment or initial cash outflow. If the result is positive, then the investor will earn a rate of return greater than the required reate of return thus the investor should consider the investment. If the result is negative then the oposite is true

Internal Rate of Return (IRR)

IRR is the discount rate that, when applied to the cash flows of an investment, equates the net cash infloes to the net cash outflows. If the IRR calculated is greate than or equal to the invesors required rate of return, then the investor should consider making the investment. If the IRR is less than the investors required rate of the return then the oposite is true. The IRR tells you the rate of return that will be realized, given the original investment amount and pjojected cash flows.

What is a Serial Payment?

(inflation adjusted rate of return also known as real rate of return)

A payment that increases at a constant rate (usually the annual rate of inflation) so as to protect the clients future purchasing power.

Real Life uses of a serial pmt : Retirement needs, life insurance needs and funding childs higher education. You will commonly see the term "in today's dollars" in the question.

Inflation-Adjusted Interest rate fomula

{[(1 + r) / (1 + i)] - 1} x 100 = I/YR

**Used in Serial payment calculations

r=nominal (before tax rate of return)

i=assumed annul inflation rate.

Serial paymet tips

After the payment has been calculated, if it is at the end of the year you must add one years worth of inflation to the payment PMT x (1+i) Each subsequent payment must also be inflated by I for each subsequnt period.

Level Payment approach (2 step process)

Instead of steadily increasing payments, these payement will be the same for the entire life of the annuity.

2 step process.

1. Inflate the goal $ amt by the level of inflation to solve for the new goal amount adjusted for inflation

2. Use the inflated goal number, r and time frame to solve for the level payment.

What is Amortization?

When monthly payments are divided between interest payable and unpaid principal. Usually used in mortgage calculations.

Mortgage Amortization calculation tips

1. Mortgages are generally calculated monthly

2. Always solve for the mortgage pmt first

3. for time frame always use 1 INPUT X 4. Shift AMORT, = toggle through principal paid, interest paid, and balance remaing on mortgage.

What is the capital utilization Method? (Annuitization)

Method in which all funds are depleted over a given period.

**Used in Retirement needs analysis, education funding and life insurance needs.

What is the Capital Retention Method? (Capital Preservation)

Payments are made to the individual are comprised of interest only.

**Most often used in calculating the amount of life insurance face value (death proceeds) that should be purchased by the client.

Capital utilization methid - Retirement Savings Calculation using level payment approach. 3 steps.

1. Inflate the payment amount based on i to get the payment in today's dollars

2. Use the payment calculated in step 1 to find the lump sum needed. Make sure to use the infltion adjusted rate of return for i.

3. Use the lump sum calculated in step to and discount according to the before tax return to find the payment needed each year leading up to retirment.

Calculating the Capital Retention method tips

Simply take the income needed, divided by the expected return. This will give you the lump sum needed. From there you must add one period of income in order to carry the client through to the next period.

A tip off that questions are Capital Retention questions is that they are asking you to calculate life insurance needs and that no time frame is given.

Define the Real Rate of Return

Nominal rate of return adjusted for the impact of inflation.

Define Taxable equivalent yield. (TEY)

Used to compare the federal tax free return of a secuity (e.g. Municipal Bond) with its taxable return equivalent.

Formula

Tax-exempt nominal yield / [1-(FTR + STR)]

FTR= Federal marginal income tax rate of the investor.

STR= State marginal income tax rate of the investor