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Hi John, I need to know how to calculate cashflows of for example it says that from year 6 to Infinity cashflows are 100 per year, so do we discount these to the current year and then divide by relevant discount factor or we don’t disclunt it to the current year I.e time zero and just divide it by relevant factor? And when calculating the total value I.e this terminal value plus the p.v of cashflows of first 5 years is there any other adjustments necessary as well?
And also what discount factor to use to project cashflows till infinty? Does it have to be annuity factor of year 6 or 5?The discount factor for flows from year 1 to infinity is 1/r (where r is the discount rate).
If you are asked to discount for year 6 to infinity, then there are two ways.
One is to multiply by 1/r and then discount for 5 years using the ordinary discount factor (because all of the flows are 5 years later than if they were 1 to infinity).
The other way is to calculate 1/r which is the discount factor for year 1 to infinity and then subtract the annuity discount factor for times 1 to 5. This will leave years 6 to infinity.
Both ways will give the same answer (apart from rounding difference using the tables – these rounding differences are irrelevant in the exam).
Sorry John I still can’t understand the first method you mentioned. Can you kindly demonstrate it if we have a cashflow of 100 with 10% discount rate!
Still thanks for explaining.OK – suppose we want the NPV of $100 p.a. starting in 6 years time and then continuing to infinity. Cost of capital 10%.
If it was 1 to infinity, we would multiply by 1/r. i.e. 1/0.1 = 10, and get a NPV of 1,000 at time 0.
However, instead of starting in 1 years time, it is starting in 6 years time – 5 years later.
So the NPV of 1,000 would be 5 years later as well – time 5 instead of time 0.So….to get the NPV at time 0, discount 1000 for 5 years using the ordinary discount factor for 5 years at 10% from the tables.
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