Page 45 - AFM Integrated Workbook STUDENT S18-J19

Investment appraisal

Illustration 2

Konta Co is evaluating a new investment project.

The forecast free cash flows are:

$000 T 0 T 1 T 2 T 3 T 4 T 5

FCF (3,500) 1,200 1,150 1,450 1,300 1,000

The company’s cost of capital is 10%.

Required:

Calculate the project’s Macaulay duration, and modified duration.

Solution

The project’s Macaulay duration is calculated by first calculating the
discounted cash flow for each future year, and then weighting each discounted
cash flow according to its time of receipt, as follows:

$000 T 1 T 2 T 3 T 4 T 5

FCF 1,200 1,150 1,450 1,300 1,000

DF @ 10% 0.909 0.826 0.751 0.683 0.621

PV 1,091 950 1,089 888 621 Σ = 4,639

PV x year 1,091 1,900 3,267 3,552 3,105 Σ = 12,915

Macaulay duration = 12,915 / 4,639 = 2.78 years

Duration considers the time value of money and all of the cash flows of a
project.

Also, modified duration is 2.78 / 1.10 = 2.53

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