Cash Flow Implied Interest Rate: A Unified Approach

Authors

  • Kavous Ardalan
  • Chester Kobos

Abstract

One of the most important topics in finance is the concept of the discounted cash flow (DCF) analysis. A recurring problem in introductory finance textbooks requires the search for the cash flow implied interest rate, that is, the implied rate of return/cost on the cash flows. There are numerous instances of such applications - for example, the calculations of the yield to maturity (YTM) and the internal rate of return (IRR). Many students regard these instances as separate, unrelated, and totally context specific exercises, despite the fact that they are the results of the same DCF method and that only the symbols have changed. This paper suggests that the solution to this problem lies in emphasizing the underlying DCF-based unified approach (UA) to the cash flow implied interest rate (CFIIR) calculation which should be explicitly brought to the attention of students in every specific instance. This paper focuses on four related aspects of the discounted cash flow analysis in an attempt to clarify and to unify the threads under the concept of the implied interest rate: namely, first, the discussion of the UA to the CFIIR calculation; second, the step-by-step illustration of the equivalency of the present value and future value calculations; third, the simultaneous consideration of the two sides to a financial contract and the understanding of the corresponding rate of return to be earned by the provider of the funds and the percentage cost to be incurred by the recipient of the funds; and fourth, the explicit definition of the multi-period rate of return to an investor. 

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Published

2001-12-01