CFA I R7 Discounted Cash Flow (DCF) Applications

Dear fellow CFA candidates/readers,

Thank you for visiting visiting WhitneyDiary CFA I Notes series, I have been using the notes below for my revision and have passed the CFA Level I on June 2018 Exam. Hereby, I share my notes with you and hope that they are helpful:

  1. Net Present Value (NPV) = ∑{CF/[(1+r)^t]}
    → Calculated using opportunity cost, discount rate, expected cash flow, timing of expected cash flow from the project
    → IRR is not used to calculate NPV
  2. a) Accept project with positive NPV;
    reject project with negative NPV.
    b) Mutually exclusive project: accept higher positive NPV project.
    c) Accept project with IRR > required rate of return;
    reject project with IRR < required rate of return.
  3. Conflict between NPV & IRR [mutually exclusive projects]
    a) Scale of investment may differ
    b) Timing of cash flow may differ
  4. Holding period return (HPR) = (Ending Value – Beginning Value)/Beginning Value
    HPR = (Ending Value/Beginning Value) – 1
    HPR = (Ending Value – Beginning Value + Cash Flow Received)/Beginning Value
  5. Money-weighted return = Internal rate of return (IRR)
    → IRR on a a portfolio, taking into account all cash inflows & outflows
    → PV (inflows) = PV (outflows)
    *Preferable performance measure if the manager has complete control over money flows into & out an account.
  6. Time-weighted rate of return = geometric mean return
    → Measures compound growth [compute HPR for each holding period]
    → Time-weighted rate of return = [(1+HPR1)(1+HPR2)^(1/2)]-1
    *Denominator of the power is determined by the number of holding period
    *Preferable measure as it is not affected by timing of CF.
    ⇒ If funds are contributed to a portfolio before a relatively poor period, money-weighted rate of return tend to be lower than the time-weighted rate of return.
  7. Bank discount yield (BDY) = (D/F) × (360/t)
    *D = Difference between F & Purchase Price
    → Express dollar discount from F
    → Ignore opportunity to earn compound interest
    *Additional Note: Add on rate (AOR) = (D/F) × (365/t)
  8. Holding Period Yield (HPY) = (P1 – P0 +D1)/ P0
    HPY = [(P1+D1)/P0] – 1
    HPY = D/Selling Price [T-bills → Price]
    → Total return an investor earns between purchase date & the sale or maturity date
    → Reflects non-annualized return an investor will earn over a security’s life.
    HPY = [BDY×(n/360)] / {1-[BDY×(n/360)]}
    HPY = rMM × (t/360)
    HPY = (1+EAY)^(n/365) – 1
  9. Effective annual yield (EAY) = (1+HPY)^(365/t) – 1
    → Annualized value, based on 365-day year, that accounts for compound interest.
  10. Money market yield (CD equivalent yield)
    → annualized HPY, assuming a 360-day year
    a) rMM = HPY × (360/t)
    b) Given rBD, rMM = (360 × rBD) / [360 – (t × rBD)
  11. HPY ⇔ rMM ⇔ EAY ⇔ BEY
    a) HPY = The actual return an investor will receive if the money market instrument is held until maturity
    b) EAY = The annualized HPY on the basis of a 365-day year & incorporates the effects of compounding
    c) rMM = The annualized yield that is based on price and a 360-day year & does not account for the effects of compounding – it assumes simple interest.
  12. Bond Equivalent yield (BEY) = 2 × semiannual discount rate
    BEY = [(1+EAY)^(t/365) – 1] × 365/t
    BEY = HPY × (365/t)
    BEY = 2 × (YTM^0.5) – 1

Thanks again for reading the notes, please like and share this post if you think my notes helpful! Do leave your comments and let me know about your thoughts!

Good luck to your exam!

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