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2. Discounted Cash Flow ________________________________ 35

3. Statistics and Market Returns___________________________ 49

4. Probabilities ________________________________________ 81

5. Key Formulas ______________________________________ 109

Candidate Note: This is a lengthy Study Session that, along with Study Session 3, you should

plan on reviewing more than once, particularly if any or all of the topic areas are new to you. We

suggest reviewing it with a CFA Institute-approved financial calculator so that you can work

through the examples and become familiar with the calculations. Study time spent on this Study

Session could benefit you greatly on exam day.

The numerical examples shown in the Quantitative Methods Study Sessions are displayed with

rounded numbers, but the calculations are done with greater precision. You may find a small

amount of what appears to be rounding error, but this is because numbers in intermediate steps

are displayed with some rounding. However, exact figures are used throughout the calculations,

and the final answers reflect this greater precision.

Note that any necessary key formulas and appendices are located at the end of Study Session 3.

Warning: Copyright violations will be prosecuted.

Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws.

2-1

Discounted Cash Flow

Learning Objectives

This summary includes a review and an analysis of the principles set forth by CFA Institute.

Upon review of this summary, you should be able to:

Calculate the net present value (NPV) and internal rate of return (IRR) of a

capital investment project ...............................................................................................pg. 36

Discuss the use of the decision rule under the net present value and internal rate

of return methods ............................................................................................................pg. 37

Discuss the problems with the internal rate of return method ......................................pg. 37

Define, calculate, and interpret holding period returns (total return) ..........................pg. 38

Differentiate between money-weighted and time-weighted rates of return ..................pg. 39

Compute and appraise the performance of a portfolio’s money-weighted and

time-weighted rates of return ..........................................................................................pg. 39

Compute the holding period yield, effective annual yield, money market yield,

and bank discount yield for a U.S. Treasury bill ...........................................................pg. 43

Convert among holding period yields, money market yields, and effective annual

yields ................................................................................................................................pg. 45

Compute bond equivalent yield (BEY) ...........................................................................pg. 46

2-35

2010 Allen Resources, Inc.

Study Session 2

Learning Objective: Calculate the net present value (NPV) and internal rate of return (IRR) of a

capital investment project.

Net present value is simply the estimated value of a project based on the cash flows it is

expected to produce. If the estimated value is positive, then accepting the project will increase

the value of the firm and, thus, increase shareholders’ wealth. The NPV method relies on

discounted cash flow (DCF) techniques and does not suffer from the shortcomings of the regular

and discounted payback methods. The steps in the NPV method are:

1. Determine each cash inflow and outflow and discount them at the project’s cost of capital

to find the present value (PV) of each.

2. Sum these discounted cash flows to produce the project’s NPV.

3. If the NPV is positive, the project should be accepted. If the NPV is negative, the project

should be rejected.

The equation for the NPV is:

NPV = CF0 + + +...+

(1 + k ) (1 + k ) (1 + k )

1 2 n

Where CF is the expected net cash flow for period t and k is the cost of capital. (Cash outflows

are treated as negative numbers and inflows are treated as positive numbers.)

Assume that a project’s cash flows consist of an initial investment of $5,000, and annual cash

inflows of $1,000, $2,000, $3,000, and $4,000. The NPV is computed as follows:

NPVs = -5,000 + + + + = $2,164

(1.12 ) (1.12 ) (1.12 ) (1.12 )

1 2 3 4

If a project has a positive NPV, then it should be accepted. An NPV of $2,164 means that if

project X is undertaken, the firm’s value (and therefore shareholders’ wealth) will increase by

$2,164 as soon as the project is accepted. If the NPV is negative, then the project should be

rejected.

The IRR is the discount rate that equates the PV of the project’s expected cash inflows to the PV

of the project’s costs. It is the rate that forces the NPV to equal zero. In the following equation, if

CF0 … CFn are known, the IRR is the rate that makes the PV of all future cash flows equal CF0,

thus producing an NPV of zero.

2-36

Study Guide for the Level I 2011 CFA Exam - Reading Highlights

Discounted Cash Flow

NPV = CF0 + + +...+ =0

(1 + IRR ) (1 + IRR ) (1 + IRR )

1 2 n

The IRR can easily be found using any financial calculator. It can also be solved through a trial-

and-error process by entering a discount rate into the formula and seeing if the equation solves to

zero. If it does not, a different rate is entered until the rate forces the equation to equal zero.

The IRR for the project in the previous section is 27.3%. If a project’s IRR is greater than the

firm’s cost of capital, then the project should be accepted. The IRR is the expected average

annual rate of return on the project. If the IRR exceeds the cost of the funds used to finance the

project, a surplus remains after paying for the capital. This surplus accrues to the stockholders,

thereby increasing shareholders’ wealth.

Learning Objective: Discuss the use of the decision rule under the net present value and internal

rate of return methods.

The NPV and IRR criteria always lead to the same accept/reject decision if independent projects

are being considered. For mutually exclusive projects, NPV is the correct method. IRR should

not be used as the selection method when choosing between mutually exclusive projects because

IRR and NPV can give conflicting results. One project can have the higher IRR while the other

project has the higher NPV.

Two conditions can cause NPV and IRR to yield conflicting rankings:

1. When the cost of one project is larger than the other.

2. When the timing of cash flows from the two projects differs so that most of the cash

flows from one project come in the early years while most of the cash flows from the

other project come in the later years.

The NPV method is therefore the preferred method for evaluating mutually exclusive projects,

especially for those projects that differ in cost and/or timing.

Learning Objective: Discuss the problems with the internal rate of return method.

If a project has abnormal cash flows, the IRR method may not be usable. Normal cash flows

occur if one or more cash outflows are followed by a series of cash inflows (and therefore there

is only one change in the signs of the cash flows). If a project requires cash outflows after cash

inflows have occurred, then the project has abnormal cash flows. (Abnormal cash flows have

more than one sign change. A negative cash flow in the middle of a project would produce three

sign changes in the cash flow stream. A negative cash flow at the end of a project would produce

two sign changes in the cash flow stream.)

2-37

2010 Allen Resources, Inc.

Study Session 2

For example, the following series of cash flows is normal: -$1,000, $500, $600, $700, and $800.

There is only one change in sign (from -$1,000 to $500). However, the following series of cash

flows is not normal: -$1,000, $500, -$600, $700, and $800. There are three changes in sign (from

-$1,000 to $500, from $500 to -$600, and from -$600 to $700).

If the IRR equation is solved for a project with abnormal cash flows, it is possible to obtain more

than one value of IRR, meaning that multiple IRRs occur. (In fact, there will be one IRR per sign

change in the cash flow stream.) In such cases, the IRR method should not be used to evaluate or

rank the project.

The IRR method also assumes that the project’s cash flows are reinvested at the IRR over the

project’s life. When a project has a high IRR, it may not be realistic to assume that the cash

flows from the project can be reinvested at that same high rate of return.

Learning Objective: Define, calculate, and interpret holding period returns (total return).

The period during which an investor owns an investment is called the holding period. The return

for the period during which an investor owns an investment is called the holding period return.

Pt − Pt −1 + Dt

HPR t =

Pt −1

Where:

For example, suppose an investor purchases an asset for $300 and gets back $330 at the end of

the year. The holding period is one year and the holding period return is ($330 − $300)/$300 =

0.10 or 10%.

The holding period return is also referred to as the total return. This is, as stated above, simply

the price appreciation (Pt − Pt−1) plus income (Dt), divided by the cost of the investment. This is

the total return of the investment. Note that this return is not necessarily annualized, but rather is

the total return of the investment over the holding period. Only under the special case of the

holding period being precisely one year, is the total return equal to the annualized return.

2-38

Study Guide for the Level I 2011 CFA Exam - Reading Highlights

Discounted Cash Flow

Money-Weighted Return

Money-weighted (MW) return is the internal rate of return on a portfolio, taking account of all

cash flows. It tries to measure return on average investment during the period. The best way to

compute a money-weighted return is to use the internal rate of return (IRR) method.

Time-Weighted Return

Time-weighted (TW) return removes the effects of the timing and amount of cash flows in and

out of the portfolio. It reflects the compound rate of growth of one unit of currency invested over

a stated measurement period.

Learning Objective: Compute and appraise the performance of a portfolio’s money-weighted and

time-weighted rates of return.

Money-weighted return is the internal rate of return (IRR), which is the Rp in the equation:

FV PMTt

PV = +

(1 + R p ) t (1 + R p )t

Where:

Example

An investment of $1,000 pays $40 at the end of each year for 5 years, plus $1,100 at the end of

the five years. What is the money-weighted rate of return?

Solution

The money-weighted rate of return will be the rate R that satisfies the equation:

$1,100 5

$40

$1, 000 = + t

(1 + Rp ) t =1 (1 + R p )

2-39

2010 Allen Resources, Inc.

Study Session 2

We can use a financial calculator’s bond function to solve this. Remember to set payments per

year equal to one if necessary (rather than the bond convention of semiannual payments):

[N] = 5

[PV] = -1000

[PMT] = 40

[FV] = 1100

[2nd] [I/Y] = 1 [ENTER]

[CE/C]

[CPT] [I/Y]

Money-weighted (MW) return is for the period and can be annualized by compounding. For

example, if we computed the quarterly MW return and we need the annual MW return, we can

compute it as follows:

Where:

Time-Weighted Return

Because open-ended mutual fund managers cannot directly control the cash inflows to their

portfolio, there is interest in a return measure that removes the effects of the timing and amount

of cash flows in and out of the portfolio.

Time-weighted return computation divides the measurement period into sub-periods. The first

sub-period starts at the beginning of the measurement period and ends with the date of the first

cash flow. The second sub-period starts the day after the first sub-period and ends on the date of

the second cash flow and so forth. The last sub-period begins the day after the last cash flow and

ends at the end of the measurement period.

TW return requires valuation of the portfolio each time a cash flow occurs. The sub-period return

is equal to the change in portfolio value during the period, divided by the total amount invested

for the period:

Return for period =

Amount invested

All sub-period returns are then compounded to arrive at the return for the measurement period:

2-40

Study Guide for the Level I 2011 CFA Exam - Reading Highlights

Discounted Cash Flow

Where:

To obtain the time-weighted average return over a period of years, take the geometric mean of

the total time-weighted return for the study period.

Example

You are Stewart Murtha, an investment manager with Clone ‘Em Equity Partners. Your fund’s

performance is shown below (figures in millions).

Period: 1 2 3 4 5

New Investments $100 $300 $250 $500 ($1,000)

Amount Invested $1,100 $1,600 $2,050 $3,000 $1,500

End Value $1,300 $1,800 $2,500 $2,500 $1,800

Assuming new investments are accepted only at the beginning of each period, find the time-

weighted average return for the entire period.

Solution

The return for period 1 is found by:

$1,300 − $1,100

Return for period = = 18.18%

$1,100

Period 1 2 3 4 5

2-41

2010 Allen Resources, Inc.

Study Session 2

By adding one to this value, and taking the fifth root of it, we can get the average annual time-

weighted return:

5

1.6214 – 1 = 10.15%

Note: This will differ from the dollar-weighted return. The dollar-weighted return will require

use of a spreadsheet or a financial calculator’s CF and IRR function. (The bond function used

earlier was useful for a simpler example.)

To compute dollar-weighted return, we must compare the net inflow and outflow for each period,

and find the interest rate which equates them over time. The beginning portfolio value should be

considered an investment (outflow), and the ending portfolio value should be considered a return

(inflow). For the example above, our net inflows and outflows for each period will be:

0 -1,100

1 -300

2 -250

3 -500

4 1,000

5 1,800

Notice the designation of the cash flow timing. The starting value in the first period is denoted as

time t = 0. Also, the net inflow of $1,000 occurs at the beginning of the 5th year, while the final

portfolio value of $1,800 is at the end of the 5th year.

[CF] [2nd] [CE/C] this clears all entries in the cash flow sheet

1100 [+/-] [ENTER]

[ ] 300 [+/-] [ENTER]

[ ][ ] 250 [+/-] [ENTER]

[ ][ ] 500 [+/-] [ENTER]

[ ][ ] 1000 [ENTER]

[ ][ ] 1800 [ENTER]

[IRR] [CPT]

Thus, the dollar-weighted return is much lower. The time-weighted return shows that the dollar-

weighted return is negatively affected by the cash flows in and out of the fund.

2-42

Study Guide for the Level I 2011 CFA Exam - Reading Highlights

Discounted Cash Flow

Learning Objective: Compute the holding period yield, effective annual yield, money market

yield, and bank discount yield for a U.S. Treasury bill.

Holding Period Yield (total return for the period, not annualized):

P1 − P0 + D1

HPY =

P0

Where P1 is the maturity value, P0 is the purchase price, and D1 is the dividend at the end of the

holding period.

P1 − P0

HPY =

P0

365

EAY = (1 + HPY) t

−1

r MM = × = HPY × = r BD × 1 =

P0 t t P0 360 − t × r BD

Bank Discount Yield (use arithmetic annualization with face value F as denominator):

D 360

r BD = ×

F t

Example

A U.S. Treasury bill, with a face value (or par value) of $100,000 and 160 days until maturity, is

selling for $97,000. Calculate its holding period yield, effective annual yield, money market

yield, and bank discount yield.

2-43

2010 Allen Resources, Inc.

Study Session 2

Solution

For a T-bill, which pays no explicit dividend D1, HPY is simply:

P1 − P0

HPY =

P0

So here, HPY = = 3.0928% .

97, 000

365 365

EAY = (1 + HPY) t

− 1 = (1 + 3.0928%) 160 − 1 = 7.1956%

r MM = × = × = 6.9588%

P0 t 97, 000 160

Bank Discount Yield (use arithmetic annualization with face value F as denominator):

r BD = × = × = 6.75%

F t $100, 000 160

Note: The price of short-term discount instruments such as Treasury bills are quoted using bank

discount yields, so we must convert from bank discount yield to price.

Example

There is a $100,000 T-bill, with 160 days to maturity, quoted at 93.25. What is the present

purchase price for this T-bill?

Solution

A quote of 93.25 means that the bank discount yield (or discount yield) is 1 – 93.25% = 6.75%.

With the discount yield, we solve for the dollar discount, D, as follows:

t 160

D = r BD × F × = 6.75% × 100, 000 × = 3, 000

360 360

With the dollar discount calculated, the purchase price for the T-bill is its face value minus the

dollar discount, F – D = $100,000 – $3,000 = $97,000.

2-44

Study Guide for the Level I 2011 CFA Exam - Reading Highlights

Discounted Cash Flow

Learning Objective: Convert among holding period yields, money market yields, and effective

annual yields.

To convert among the three versions of short term yields, you need to know that all those yields

come from three pieces of basic information: the present value (PV), the future value or face

value (FV), and the number of days in between.

The Holding Period Yield is the total return for the specific period. It is not annualized:

P1 − P0 + D1

HPY =

P0

The Effective Annual Yield is the holding period return annualized using 365-day compounding:

365

EAY = (1 + HPY) t

−1

The Money Market Yield or CD-Equivalent Yield is the holding period yield annualized using

360-day convention with no compounding:

D 360 360

r MM = × = HPY ×

P0 t t

So the key is to remember that Holding Period Yield is for the holding period only, not

necessarily for the year. Effective Annual Yield is annualized HPY using 365-day compounding.

Money Market (CD) Yield is annualized HPY using 360-day convention with no compounding.

Example

Suppose a savings instrument produces a holding period return of 5% for 180 days. Find the

effective annual yield and the CD-equivalent yield.

Solution

365

EAY = (1 + 0.05)180 − 1 = 10.40%

360

r MM = 0.05 × = 10.00%

180

Example

A 270-day CD produces a CD-equivalent of 7.25%. Find the holding period yield and the

effective annual yield.

2-45

2010 Allen Resources, Inc.

Study Session 2

Solution

360

r MM = 0.0725 = HPY × ; HPY = 5.4375%

270

Therefore:

365

EAY = (1 + 0.054375) 270 − 1 = 7.4202%

Example

An effective annual yield for a 90-day security is 5.50%. Find the holding period yield and the

money market equivalent yield.

Solution

365

0.055 = (1 + HPY) 90 − 1

365

ln(1.055) = × ln (1 + HPY )

90

0.013201833 = ln (1 + HPY )

ln (1 + HPY )

e0.013201833 = e

1.013289362 = 1 + HPY

HPY = 1.3289362%

360

r MM = 0.013289362 × = 5.3157%

90

Periodic bond yields for both straight and zero-coupon bonds are conventionally computed based

on semiannual periods, as U.S. bonds typically make two coupon payments per year. For

example, a zero-coupon bond selling at $553.68 with a maturity of ten years will mature in

twenty 6-month periods. To get the periodic yield for that bond, r, we can solve the equation:

to get r = 3%.

2-46

Study Guide for the Level I 2011 CFA Exam - Reading Highlights

Discounted Cash Flow

This yield r of 3% is, of course, an internal rate of return with semiannual compounding. In bond

market terminology, it is the semiannual yield to maturity. How do we annualize it?

The convention is to double it and call the result the bond’s yield to maturity. In our example, the

semiannual yield to maturity is 3%; the bond’s yield to maturity is 6%. The yield to maturity

calculated in this way, which ignores compounding for the six months, is a bond-equivalent

yield. Annualizing a semiannual yield by doubling it is putting the yield on a bond-equivalent

basis. This yield to maturity (on a bond-equivalent basis) is the actual yield quoted in markets. It

is the one we use in talking to a bond dealer.

Warning: Copyright violations will be prosecuted.

Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws.

2-47

2010 Allen Resources, Inc.

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