Chapter 17 - Fundamentals of Discounted Cash Flow Analysis

How are the projected future sales proceeds estimated for figuring the net present value of a cash flow stream? A.) The cash flow for the final year is divided by a cap rate. B.) The cash flow for the final year is projected one year further, divided by a cap rate, and reduced for estimated sales costs. C.) The cash flow for the final year is divided by the discount rate and reduced for estimated sales costs. D.) The original acquisition cost is compounded by an interest rate to represent appreciation.

B.) The cash flow for the final year is projected one year further, divided by a cap rate, and reduced for estimated sales costs.

What is compounding

Applies to determining how money accumulates between the present time and some future time; it calculates the future value of a present amount.

Compounding is a three-step process:

(1) An amount is invested and earns interest over a period (2) The interest is added too the original amount (3) Interest in the next period is added to the new total

The process of discounting entails reducing a future amount of money through the application of.....

An annual discount rate. The rate is applied once if the money is spent or received one year in the future; the rate is applied twice if two years, and so on.

If an investment is purchased for $100, creates income of $10 each year for 3 years, and is sold after year 3 for net proceeds of $115, which of the following represents the correct cash flow stream (reading earlier to later, left to right)? A.) -$100, $10, $10, $125 B.) -$90, $10, $10, $10, $115 C.) -$90, $10, $10, $125 D.) -$100, $10, $10, $10, $115

A.) -$100, $10, $10, $125

For which of the following situations would time value of money calculations be necessary? A.) Comparing lease vs. own alternatives B.) Calculating current net operating income C.) Estimating closing costs D.) Calculating cash-on-cash return

A.) Comparing lease vs. own alternatives

Describe the discounting process

An interest rate (the discount rate) is applied to a future amount to reduce it to a present amount. The process is repeated for each payment period of the holding period.

What is the difference between discounting a single future amount and discounting a stream of cash flows

Discounting a cash flow stream is simply discounting each individual cash flow and totaling all the present values.

What is discounting

Enables us to determine the amount of money in the present time we would have to invest to achieve a certain amount in the future; it calculates the present value of a future amount.

What are outflows

Expenses and investment expenditures

In regards to inflow/outflow, what is important to remember

If inflow numbers are positive, outflow numbers must be negative. If inflow numbers are negative, outflow numbers must be positive.

What are inflows

Income or investment returns

Where does the analyst get the discount rate to use in discounting

Investors typically have an interest rate that they want to use, based on consideration of other interest and lending rates, cost of opportunity, cost of capital, required returns, acceptable risk, inflation, and competing investments.

How does Net Present Value differ from Present Value

Present value does not include the cost of acquiring the investment or the potential reversionary value from selling it in the future. Net Present Value includes both of these in the cash flow streams to be discounted.

Explain Discounted Cash Flow (DCF) analysis

Since amounts paid out or received in the future are worth less than their face amounts in today's dollars, it is necessary to discount the entire cash flow stream to determine its present value.

How is the average annual gain of an investment calculated

The NPV is divided by the initial investment amount to reveal the total gain as a percentage; this total gain is then divided by the number of years in the holding period to get the annual average.

The higher the discount rate used, the _______ the present value of a future amount will be

smaller

The value of money is related to time in 2 basic ways:

(1) Money accumulates over time if it is invested in some kind of growth instrument, such as an interest-bearing bank account. (2) Money loses value over time because of the effects of inflation.

The steps to net present value:

(1) Project the operating statement out one year beyond the holding period to derive an NOI for that year. (2) Apply a cap rate to the estimated NOI for that year to get an estimated selling price. (3) Reduce that amount by estimated costs of the sale to estimate net sales proceeds. (4) Add the net proceeds to the cash flow from operations for the last year of the holding period.

To complete the analysis of a commercial property, these two items must be included in the stream of NOI cash flows

(1) The initial cost of acquiring the investment (2) The projected reversionary value to be received when the investment is sold in the future

In discounting cash flow streams over time, there are two important points to note:

(1) timing of cash flow amounts, or when incurred (2) direction of flow— out or in

How is it that a future dollar amount is "worth" more or less than the same amount in present dollars

A future amount includes a portion attributable to earnings from interest that could have been earned on a present amount. If the interest contribution is removed from the future amount, the "actual" value of the future amount is revealed to be less than that of the present amount. Also, money loses value over time to inflation and gains value when it earns interest.

The present value of a stream of cash flows is equal to A.) the sum of the present values of each single cash flow. B.) the present value of the sum of the nominal cash flows. C.) the average of all cash flows multiplied by the discount rate. D.) the average of all cash flows divided by the discount rate.

A.) the sum of the present values of each single cash flow.

Describe the compounding process

An interest rate is applied to an initial present amount. The interest is added to the original amount and the interest rate is applied again to the new total. The process is repeated for each payment period over the entire holding period

Why are the income and expenses for the two properties in the apartment comparison projected one year beyond the investment holding period? A.) To verify that the escalation trend would continue B.) To obtain a "next year" NOI as a basis for estimating a selling price C.) To obtain an additional cash flow to offset the "year zero" cash flow D.) To make the Net Present Value appear more realistic

B.) To obtain a "next year" NOI as a basis for estimating a selling price

In which of the following ways did the Maeve Building turn out to be a better investment than The Kinza building? A.) Greater nominal dollar return. B.) Larger Net Present Value. C.) Higher average annual gain. D.) Greater reversionary value.

C.) Higher average annual gain.

To calculate a present value A.) multiply a future amount by a discount rate. B.) divide a future amount by a discount rate. C.) divide a future amount by 100% plus a discount rate. D.) subtract an initial amount from its future value.

C.) divide a future amount by 100% plus a discount rate.

Why is the timing of payments important

The closer a payment is to the represent time, the closer it will approximate to the value in present dollars.

Why is it better to receive a certain cash flow next year than five years from now? Conversely, why is it better to spend a certain amount five years from now than next year

The closer the cash flow is to the present, the closer it is to its present value, and hence the larger it is. Receive as soon as possible, spend as late as possible.

Explain Net Present Value (NPV)

The present value of the cash flow stream with the difference between the initial cost of the investment and the residual proceeds figured in.