This document contains all the crucial information described in Chapter 4 of the Corporate Finance: A focused approach book. These notes contain all the information to prepare yourself for the exam with the information of this chapter.
of all the concepts used in finance, none is more important than the time value of money (TVM) ,
also called discounted cash flow (DCF) analysis .
discounted cash flow (DCF) analysis
The method of determining today’s value of a cash flow to be received in the future. Because a
dollar in the future is worth less than a dollar today, the process of equating today’s dollars with
future dollars is called discounting. Also called the time value of money analysis. DCF analysis
can be used to estimate a financial asset’s value by finding the present value of the asset’s
expected cash flows when discounted at rate that reflects the asset’s risk. This method can be
applied to the cash flows from bonds, stocks, entire companies, and specific projects.
time line
A graphical representation used to show the timing of cash flows.
The first step in a time value analysis is to set up a time line to help you visualize what’s
happening in the particular problem.
The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is
today, and it is the beginning of Period 1; Time 1 is one period from today, and it is both the end
of Period 1 and the beginning of Period 2; and so on. Thus, if the periods are years, the tick mark
at Time 2 represents both the end of Year 2 and the beginning of Year 3.
In this example, cash flows occur only at Times 0 and 3, with no flows at Times 1 or 2.
Note also that in our example the interest rate is constant for all 3 years.
A dollar in hand today is worth more than a dollar to be received in the future; if you had the
dollar now, you could invest it, earn interest, and end up with more than one dollar in the future.
The process of going forward, from present values (PVs) to future values (FVs), is
called compounding.
compounding
The process of finding the future value of a single payment or series of payments. The
compounding is based on periodic interest rates unless using continuous compounding.
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