CFA 2018 smart summary, study session 02, reading 07 copy 1

2017, Study Session # 2, Reading # 7

“DISCOUNTED CASH FLOW APPLICATIONS”
NPV = Net Present Value

D.R. = Discount Rate.
IRR

NPV:

The D.R. at which NPV = 0.
The rate of return at which;
PV inflows = PV outflows.
It assumes reinvestment at
IRR.

PV of expected – PV of expected
cash inflows.
cash outflows.

NPV =

IRR > r

⇒

Accept

IRR < r

⇒

Reject

Decision rule:

Select the project with the
greatest NPV.

Problems in IRR

NPV

Decision

+ve (IRR> r)

Accept

0

-

-ve (IRR< r)

Reject

Money-Weighted Return
(MWR)
IRR of an investment.
It is highly sensitive to the

timing & amount of
withdrawals from & additions
to a portfolio.
If one has complete control
over the timings of the cash
flows then it is more
appropriate.

Funds contributed
prior to a period of
relatively.

IRR / NPV rules lead to
exactly the same accept
/reject decision

For Mutually Exclusive
Projects:

Decision rule
D.R used is the market based opportunity
cost of capital.
NPV assumes reinvestment at D.R.

For Independent Project:

For mutually exclusive projects, NPV & IRR
may give conflicting project rankings due to:

Impact

shareholder’s wealth.

Size of the company rises
but shareholder’s wealth is
not affected.

Different sizes of
project’s initial cost

shareholder’s wealth.

Time-Weighted Return (TWR)
It measures compound
growth (Geometric return).
It is not affected by the
timings of cash flows.
It is preferred over MWR.
TWR cannot be calculated if
we do not know the period
end values of investment.

Poor returns

MWR < TWR

High returns

MWR > TWR

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Differences in timings of
cash flows.


2017, Study Session # 2, Reading # 7

Holding Period Yield or
Holding Period Return (HPR)

Money Market Yield
(CD equivalent yield) rMM

Total return an investor earns between the purchase
date & the sale or maturity date.
ܲଵ −ܲ଴ + ‫ܦ‬ଵ
ܲଵ + ‫ܦ‬ଵ
=
−1
ܲ଴
ܲ଴
It is the actual return an investor receives.
‫= ܴܲܪݎ݋ܻܲܪ‬

Annualized HPY.
Assumes 360-day year.
Does not incorporate
effects of compounding.
‫ݎ‬ெெ = ‫ × ܻܲܪ‬360/‫ݐ‬

Bank Discount Yield (rBD)
Dollar discount from the
face (par) value as a
fraction of the face value.
Based on face value.
Not based on market or
purchase price.
‫ݎ‬஻஽ = ‫ܦ‬/‫ × ܨ‬360/‫ݐ‬

Effective Annual Yield
(EAY)
Annualized HPY.
Assumes 365-day year.
Incorporates effects of
compounding.
365/ t
EAY =(1+HPY)
-1

Converting rBD into rMM
‫ݎ‬ெெ =

360 × ‫ݎ‬஻஽
360–(‫ݎ × ݐ‬஻஽ )

Bond –equivalent yield
(BEY)
BEY = 2 × (semi annual
effective yield.)

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