Chapter2. The Basic Theory of Interest || Part2

2.3 Present and Future Values of Streams

 

Future Value

• This formula for future value always uses the interest rate per period and assumes that interest rates are compounded each period

Present Value

• Present value of a cash flow is the present payment amount that is equivalent to the entire stream

2.4 Internal Rate of Return

 

IRR

• IRR is defined without reference to a prevailing interest rate

• Determined entirely by the cash flows of the stream

• Higher internal rate of return means the rate of return from investing V0 is high

• For any cash flow stream, the IRR is the interest rate that makes the present value of the stream to be zero

 

2.5 Evaluation Criteria

 

Evaluation with Net Present Value

• Alternatives with higher present values are more desirable

• All cash flows associated with the investment must be included (both positive and negative)

• Net present value (NPV): Present value of benefits minus the present value of costs

• Only investments with positive NPV are worthy of consideration

Evaluation with Internal Rate of Return

• Alternatives with higher IRR are more desirable

• Investment is not worth considering unless its IRR is greater than the prevailing interest rate

  (IRR이 이자율보다 높지 않으면 투자 가치가 없습니다, 여기서는 비슷한 위험도라는 가정하에!)

NPV vs IRR

• NPV: simplest to compute; can be broken into component pieces

• IRR: depends only on the properties of the cash flow stream; does not require external interest rate

• For one-time investments, NPV may be more appropriate

• If future cash flows from reinvestment were modeled, NPV may provide  the same recommendation as IRR

• One approach is to use NPV as the first evaluation criterion and check IRR to confirm the result

• NPV and IRR are good starting points but other factors also need to be considered