The Intrinsic Value of an investment is the discounted value of anticipated cash flows.

What is Time Value of Money ?

Time Value of Money explicitly incorporates the idea that a dollar received today is worth more than a dollar to be received a year from now because today's dollar can be invested to earn a rate of return over the next year. Essentially, the link between Income and Capital is the Rate of Return as the percentage of premiums paid at one date in terms of money to be on hand one year later.

What is Discount Factor ?

Discount Factor is the rate at which the future cash flows are multiplied to arrive at the present value of cash flows. The Rate of Return or Discount Rate not only includes compensation for bearing risk but also the expected rate of inflation. For example if the Rate of Return is 10% then the discount factor for year 1 is 0.909 (1/1.1) and for year 2 it is 0.826 (1/1/21).

Table 3 illustrates the Time Value of Money and compute the Intrinsic Value of cash flows for 100 Years based on the following assumptions:

Assumptions

Cash Flows in Prior Period | 100 |

CAGR of Cash Flows (1st to 10th Year) | 15% |

Terminal Period Cash Flows will grow at an Inflation of 3% for 11th to 100th Year | 3% |

Discount Rate or Cost of Capital | 10% |

I have taken a discount rate of 10%, so the next year if we reinvest 1, it should become 1.1 and then 1.21 and so forth. Thus, the Time Value of Money today for Year 1 is (1/1.1) or 0.909, (1/1.21) or 0.826 for Year 2, and so forth. Using this Discount Factor, we need to multiply the cash flows with the discount factor to arrive at the present value.

## Present Value of Cash Flows

The cash flows have been divided into two parts - Forecast Period and Terminal Period.

In the Forecast Period, the Cash Flow is 100 in Year Zero and is assumed to grow at 15% compounded for 10 Years. Then, during the Terminal Period, it is assumed to grow at an inflation rate of 3%.

The cash flows have then been multiplied by the discount factor (discount rate is taken at 10%) for that year to arrive at the present value for that year. Then, we sum all the present values to arrive at the Cumulative Present Value of Cash Flows (Years 1 – 100) which gives us the Capitalized Value of the Cash Flows at a Discount Rate of 10%.

Table 3Time Value - Cash Flows | |||||||||||

Forecast Period | Terminal Period | ||||||||||

Year | Cash Flows | Growth | Discount Rate - 10% | Discount Factor | PV of Cash Flows | Year | Cash Flows | Inflation 3% | Discount Rate - 10% | Discount Factor | PV of Cash Flows |

0 | 100 | ||||||||||

1 | 115 | 15% | 1.10 | 0.909 | 105 | 11 | 417 | 3% | 2.85 | 0.350 | 146 |

2 | 132 | 15% | 1.21 | 0.826 | 109 | 12 | 429 | 3% | 3.14 | 0.319 | 137 |

3 | 152 | 15% | 1.33 | 0.751 | 114 | 13 | 442 | 3% | 3.45 | 0.290 | 128 |

4 | 175 | 15% | 1.46 | 0.683 | 119 | 14 | 455 | 3% | 3.80 | 0.263 | 120 |

5 | 201 | 15% | 1.61 | 0.621 | 125 | 15 | 469 | 3% | 4.18 | 0.239 | 112 |

6 | 231 | 15% | 1.77 | 0.564 | 131 | 16 | 483 | 3% | 4.59 | 0.218 | 105 |

7 | 266 | 15% | 1.95 | 0.513 | 137 | 17 | 498 | 3% | 5.05 | 0.198 | 98 |

8 | 306 | 15% | 2.14 | 0.467 | 143 | 18 | 512 | 3% | 5.56 | 0.180 | 92 |

9 | 352 | 15% | 2.36 | 0.424 | 149 | 19 | 528 | 3% | 6.12 | 0.164 | 86 |

10 | 405 | 15% | 2.59 | 0.386 | 156 | 20 | 544 | 3% | 6.73 | 0.149 | 81 |

- | |||||||||||

- | |||||||||||

99 | 5617 | 3% | 12528 | 0.00008 | 0.448 | ||||||

100 | 5785 | 3% | 13781 | 0.00007 | 0.42 | ||||||

Cumulative Present Value of Cash Flows - Forecast Period | 1287 | Cumulative Present Value of Cash Flows - Terminal Period | 2291 | ||||||||

Present Value of Cash Flows - Forecast + Terminal | 3578 |

The Present Value of Cash Flows during the forecast period is 1287 and during the terminal period (post the forecast period) is 2291. The sum of forecast and terminal period is 3578, which is the Intrinsic Value.