Reading 7 Discounted Cash Flow Applications Introduction
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As investment analysts, much of our work includes evaluating transactions involving present and future cash flows. In the reading on the time value of money (TVM), we presented the mathematics needed to solve those problems and illustrated the techniques for the major problem types. In this reading we turn to applications. Analysts must master the numerous applications of TVM or discounted cash flow analysis in equity, fixed income, and derivatives analysis as they study each of those topics individually. In this reading, we present a selection of important TVM applications: net present value and internal rate of return as tools for evaluating cash flow streams, portfolio return measurement, and the calculation of money market yields. Important in themselves, these applications also introduce concepts that reappear in many other investment contexts.
The reading is organized as follows. Section 2 introduces two key TVM concepts, net present value and internal rate of return. Building on these concepts, Section 3 discusses a key topic in investment management, portfolio return measurement. Investment managers often face the task of investing funds for the short term; to understand the choices available, they need to understand the calculation of money market yields. The reading thus concludes with a discussion of that topic in Section 4.