1. NPV Function
Now, let's talk about some handy Excel functions that can help when discounting
cash flows. The NPV function is used in Excel to quickly calculate that
present value, there are a couple of key assumptions when using NPV.
One, the NPV is calculated by discounting all cash flows.
This is important as it makes it different from a very similar function.
Two, cash flows are assumed to occur at regular intervals, for instance,
annually. Three, cash flows occur at the end of the period.
The NPV function syntax has the following components: One, the discount
rate, two, cash flow values for a certain number of periods that are
equally spaced and occur at the end of the period.
And while the NPV function is a useful tool
in calculating the present value of a stream of Cash Flows,
it's not entirely accurate in dealing with cash flows that occur sporadically
over a period. Of course, in real life, cash flows don't typically occur
at the end of the year, they occur throughout the year.
So one assumption we often make in a DCF
is to assume the cash flows occur in the middle of the year
or mid period. This will slightly increase the present value of those cash
flows. But that presents us with a problem,
since the NPV function assumes that cash flows happen at the end of
the period. However, there is a quick solution to this problem.
To apply mid period discounting using the NPV function,
multiply the NPV by one plus the discount rate. With that,
take in to the power of 0.5 or half a year.
So basically, we compound the cash flows at WACC by half a period.
This is equivalent to discounting the cash flows at the middle of the
year.
2. Let's practice!