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24Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition

Chapter4
TimeValueofMoney:
ValuingCashFlowStreams

Note: AllproblemsinthischapterareavailableinMyFinanceLab.Anasterisk(*)indicatesproblems
withahigherlevelofdifficulty.

EditorsNote: Aswemoveforwardtomorecomplexfinancialanalysis,thestudentwillnoticethatsome
problemsmaycontainalargeamountofdatafromdifferenttimeperiodsthatrequire
morecomplicatedandintensiveanalysis.Moderninformationtechnologyhasevolvedin
theformoffinancialcalculatorswithbuiltinanalysisfunctionsandTimeValueofMoney
functionsthatarebuiltintocomputerbasedelectronicspreadsheetsoftwaresuchasExcel.
Thesolutionsformanydataandcomputationallyintensiveproblemswillbepresentedin
formulaformwithasolution,aswellaswiththeappropriatefinancialcalculatorcommands
andExcelfunctionstoproducethesamecorrectanswer.Inthisway,itisourexpectation
thatstudentswilldevelopproficiencyinsolvingfinancialanalysisproblemsbymathematical
calculationaswellasbyusingfinancialcalculatorsandelectronicspreadsheets.

1.
0 1 2 3 4 5

4000 1000 1000 1000 1000 1000


Fromthebanksperspective,thetimelineisthesameexceptallthesignsarereversed.

2.

300 300 300 300 300

Fromthebanksperspective,thetimelinewouldbeidenticalexceptwithoppositesigns.

2012PearsonEducation,Inc.PublishingasPrenticeHall
25Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
3. Plan:DrawthetimelineandthencomputetheFVofthesetwocashflows.

Execute:
Timeline(sincewearecomputingthefuturevalueoftheaccount,wewilltreatthecashflowsas
positivegoingintotheaccount):
0 1

500 300
FV?
FV500(1.03)300815

Evaluate:
Thetimelinehelpsusorganizeourworksothatwegetthenumberofperiodsofcompounding
correct.Thefirstcashflowwillhave1yearofcompounding,butthesecondcashflowwillbe
depositedattheendofperiod1,soitreceivesnocompounding.

4. EditorsNote:Inseveralpreviousproblemsweusedafinancialcalculatortosolveatimevalue
ofmoneyproblem.ProblemscouldbesolvedquicklyandeasilybymanipulatingtheN,I/Y,
PV,PMT,andFVkeys.Ineachoftheseproblemstherewasaseriesofpayments,ofequal
amount,overtime,i.e.,anannuity.Allyouhadtodotoinputthisserieswasenterthepayment
(PMT)andthenumberofpayment(N).

Manyfinancialanalysisproblemsinvolveaseriesofequalpayments,butothersinvolveaseries
ofunequalpayments.Afinancialcalculatorcanbeusedtoevaluateanunequalseriesofcash
flows(usingthecashflow(CF)key),buttheprocessiscumbersomebecauseeachcashflow
mustbeenteredindividually.IurgeeachstudenttostudytheChapter4Appendix:Usinga
FinancialCalculator,aswellasinstructionalmaterialsthatareproducedbythemanufacturers
ofthefinancialcalculator.

Herewewillsolveaproblemwithunevencashflowsmathematicallyandwithafinancial
calculator.

Plan:Itiswonderfulthatyouwillreceivethiswindfallfromyourinvestmentinyourfriends
business.Sincethecashflowpaymentstoyouareofdifferentamountsandpaidover3years,
therearedifferentwaysinwhichyoucanthinkabouthowmuchmoneyyouarereceiving.

Execute:
10,000 20,000 30,000
PV
1.035 1.0352 1.0353
a.
9662 18,670 27,058
55,390
0 1 2 3

10,000 20,000 30,000

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams26
TheTexasInstrumentBAIIPLUScalculatorhasacashflowworksheetaccessedwiththe
CFkey.ToclearallpreviousvaluesthatmightbestoredinthecalculatorpresstheCF,
second,andCE/Cbuttons.ThescreenshouldshowCFoaskingforthecashflowattime0,
whichinthisproblemis0.Press0,thenpressenter,andthenthedownkeybutton.The
screenshouldshowCO1askingforthecashflowattime1,whichinthisproblemis10,000.
Input10,000followedbytheenterkey,followedbythedownbutton.Thescreenshould
showFO11.0askingforthefrequencyofthiscashflow.Sinceitoccursonlyonce,itis
correct,andwepressthedownkey.ThescreennowhasCO2askingforthetime2cash
flow,whichis20,000,whichweinput,followedbytheenterkeyandthedownkey.The
screennowhasFO21.0,whichiscorrect.Enterthedownkey,whichasksforthethird
cashflow,whichis30,000.Input30,000,followedbytheenteranddownkeys.Nowpress
theNPVkeyanditwilldisplayIaskingfortheinterestrate,whichis3.5.Input3.5,press
enterkey,andpressthedownkeyandthescreenwilldisplayNPVThenpresstheCPT
buttonandthescreenshoulddisplay55,390.33,theNetPresentValue.
FV 55,390 1.0353
b.
61,412
0 1 2 3

10,000 20,000 30,000

Evaluate:Youmayask:HowmuchbetteroffamIbecauseofthiswindfall?Thereare
severalanswerstothisquestion.Thevaluetoday(i.e.,thepresentvalue)ofthecashyouwill
receiveover3yearsis$55,390.Ifyoudecidetoreinvestthecashflowsasyoureceivethem,
thenin3yearsyouwillhave$61,412(i.e.,futurevalue)fromyourwindfall.

5. Plan:UseEq.4.3tocomputethePVofthisstreamofcashflowsandthenuseEq.4.1tocompute
theFVofthatpresentvalue.Toanswerpart(c),youneedtotrackthenewdepositmadeeach
yearalongwiththeinterestonthedepositsalreadyinthebank.

Execute:
100 100 100
PV 257.71
a.andb. (1.08) (1.08) (1.08)3
2

FV 257.71(1.08)3 324.64
Year1:100
c. Year2:100 1.08 100 208
1

Year3:208(1.08)1 100 324.64

Evaluate:
ByusingthePVandFVtools,weareabletokeeptrackofourbalanceaswellasquickly
calculatethebalanceattheend.Whetherwecomputeitstepbystepasinpart(c)ordirectlyas
inpart(b),theansweristhesame.

2012PearsonEducation,Inc.PublishingasPrenticeHall
27Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
6. Plan:First,createatimelinetounderstandwhenthecashflowsareoccurring.

0 1 2 3

1000 1000 1000


Second,calculatethepresentvalueofthecashflows.

Onceyouknowthepresentvalueofthecashflows,computethefuturevalue(ofthispresent
value)atdate3.
1000 1000 1000
PV
1.05 1.052 1.053
Execute:
952 907 864
2723

N I/Y PV PMT FV ExcelFormula


Given: 3 5.00% 1000 0
SolveforPV: 2723.25 PV(0.05,3,1000,0)

FV3 2723 1.053


3152

N I/Y PV PMT FV ExcelFormula


Given: 3 5.00% 2723.43 0
SolveforFV: 3152.71 FV(0.05,3,0,2723.43)

Evaluate:Becauseofthebanksoffer,younowhavetwochoicesastohowyouwillrepaythis
loan.Eitheryouwillpaythebank$1000peryearforthenext3yearsasoriginallypromised,or
youcandecidetoskipthethreeannualpaymentsof$1000andpay$3152inyearthree.

Younowhavetheinformationtomakeyourdecision.

7. Plan:Thisscholarshipisaperpetuity.Thecashflowis$10,000andthediscountrateis7%.
WecanuseEq.4.4tosolveforthePV,whichistheamountyouneedtoendow.

Execute:
Timeline:
0 1 2

10,000 10,000

PV10,000/0.07142,857.14

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams28
Evaluate:
Withadonationof$142,857.14todayand7%interest,theuniversitycanwithdrawtheinterest
everyyear($10,000)andleavetheendowmentintacttogeneratethenextyears$10,000.Itcan
keepdoingthisforever.

8. Plan:Thisisadeferredperpetuity.Hereisthetimeline:

0 1 2 10 11


0 0 10,000 10,000

Dothisintwosteps:
1. Calculatethevalueoftheperpetuityinyear9,whenitwillstartinonlyoneyear
(wealreadydidthisinproblem7).
2. Discountthatvaluebacktothepresent.

Execute:
Thevalueinyear9is10,000/0.07142857.14.
142857.14
Thevaluetodayis 77704.82 .
1.079

Evaluate:
Becauseyourendowmentwillhave10yearstoearninterestbeforemakingitsfirstpayment,
youcanendowthescholarshipformuchless.Thevalueofyourendowmentmustreach
$142,857.14theyearbeforeitstarts(in9years).Ifyoudonate$77,704.82today,itwillgrowat
7%interestfor9years,justreaching$142,857.14,oneyearbeforethefirstpayment.

9. Thetimelineforthisinvestmentis:

0 1 2 3

100 100 100

a. Thevalueofthebondisequaltothepresentvalueofthecashflows.Bytheperpetuity
formula,whichassumesthefirstpaymentisatperiod1,thevalueofthebondis:

100
PV
0.04
2500

2012PearsonEducation,Inc.PublishingasPrenticeHall
29Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
b. Thevalueofthebondisequaltothepresentvalueofthecashflows.Thefirstpaymentwillbe
receivedattimezero.Thecashflowsaretheperpetuityplusthepaymentthatwillbe
receivedimmediately.

100
PV 100
0.04
2600

10. Plan:Drawthetimelineofthecashflowsfortheinvestmentopportunity.ComputetheNPVof
theinvestmentopportunityat7%interestperyeartodetermineitsvalue.

0 1 2 3 100

1000 1000 1000 1000


Execute:Thecashflowsarea100yearannuity,sobytheannuityformula:

1000 1
PV 1
0.07 1.07100
14,269.25

N I/Y PV PMT FV ExcelFormula


Given: 100 7.00% 1000 0
SolveforPV: (14,269.25) PV(0.07,100,1000,0)

Evaluate:ThePVof$1000tobepaideveryyearfor100yearsdiscounttothepresentat7%is
$14,269.25.

11. Plan:Prepareatimelineofyourgrandmothersdeposits.

0 1 2 3 18

1000 1000 1000 1000

Thedepositsarean18yearannuity.UseEq.4.6tocalculatethefuturevalueofthedeposits.

1 1
Execute: FV C ((1 r ) N 1) 1000 ((1.03)18 1) 23,414.43
r .03

N I/Y PV PMT FV ExcelFormula


Given: 18 3.00% 0 1000
SolveforFV: (23,414.43) FV(0.03,18,1000,0)

Atage18youwillhave$23,414.43inyouraccount.

Evaluate:

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams30
Theinterestonthedepositsandinterestonthatinterestaddsmorethan$5414totheaccount.
12. a.
0 1 2 3 18

C C C C

First,weneedtocalculatethePVof$160,000in18years.

160,000
PV
(1.08)18
40,039.84

N I/Y PV PMT FV ExcelFormula


Given: 18 8.00% 0 160,000
SolveforPV: (40,039.84) PV(0.08,18,0,160000)

Inorderfortheparentstohave$160,000inyourcollegeaccountbyyour18thbirthday,
the18yearannuitymusthaveaPVof$40,039.84.Solvingfortheannuitypayments:

40,039.84
C
1 1
1
0.08 1.0818
$4272.33

whichmustbesavedeachyeartoreachthegoal.

N I/Y PV PMT FV ExcelFormula


Given: 18 8.00% 40,039.84 0
SolveforPMT: (4,272) PMT(0.08,18,40039.84,0)

b. First,weneedtocalculatethePVof$200,000in18years.

200,000
PV
(1.08)18
50,049.81

N I/Y PV PMT FV ExcelFormula


Given: 18 8.00% 0 200,000
SolveforPV: (50,049.81) PV(0.08,18,0,200000)

2012PearsonEducation,Inc.PublishingasPrenticeHall
31Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
Inorderfortheparentstohave$200,000inyourcollegeaccountbyyour18thbirthday,
the18yearannuitymusthaveaPVof$50,049.81.Solvingfortheannuitypayments:

$50,049.81
C
1 1
1
0.08 1.0818
$5340.42

whichmustbesavedeachyeartoreachthegoal.

N I/Y PV PMT FV ExcelFormula


Given: 18.00 0.08 50,049.81 0.00
5340.4
SolveforPMT: 2 PMT(0.08,18,50049.81,0)

*13. Plan:

a. Drawthetimelineofthecashflowsfortheloan.
1 2 3 4 5
0 1 2 3 4

5000 5000 5000 5000

Topayofftheloanyoumustrepaytheremainingbalance.Theremainingbalanceisequal
tothepresentvalueoftheremainingpayments.Theremainingpaymentsarea4year
annuity,so:

b.
4 5
0 1

5000
Execute:
5000 1
PV 1
a. 0.06 1.06 4
17,325.53

N I/Y PV PMT FV ExcelFormula


Given: 4 6.00% 5000 0
SolveforPV: (17,325.53) PV(0.06,4,5000,0)

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams32
5000
PV
b. 1.06
4716.98

Evaluate:Topayofftheloanafterowningthevehiclefor1yearwillrequire$17,325.53.
Topayofftheloanafterowningthevehiclefor4yearswillrequire$4716.98.

14. Plan:Thisisadeferredannuity.Thecashflowtimelineis:

0 1 17 18 21
0 0 100,000 100,000

Calculatethevalueoftheannuityinyear17,oneperiodbeforeitstartsusingEq.4.5andthen
discountthatvaluebacktothepresentusingEq.4.2.

Thevalueoftheannuityinyear17,oneperiodbeforeitistostartis:

CF 1 100,000 1
PV 1 n
1 4 331,212.68
r (1 r ) 0.08 (1.08)

Togetitsvaluetoday,weneedtodiscountthatlumpsumamountback17yearstothepresent:

331,212.68
$89,516.50
(1.08)17

Evaluate:
Eventhoughthecashflowsarealittleunusual(anannuitystartingwellintothefuture),wecan
stillvaluethembycombiningthePVofannuityandPVofaFVtool.Ifweinvest$89,516.50
todayataninterestrateof8%,itwillgrowtobeenoughtofundanannuityof$100,000peryear
bythetimeitisneededforcollegeexpenses.

15. Plan:Thisisadeferredannuity.Thecashflowtimelineis:

0 1 44 45 60
0 0 40,000 40,000

Calculatethevalueoftheannuityinyear44,oneperiodbeforeitstartsusingEq.4.5andthen
discountthatvaluebacktothepresentusingEq.4.2.

Execute:
Thevalueoftheannuityinyear44,oneperiodbeforeitistostartis:

CF 1 40,000 1
PV 1 n
1 377,865.94
r r (1 r ) 0.07 (1.07) 16

Togetitsvaluetoday,weneedtodiscountthatlumpsumamountback44yearstothepresent:

377,865.94
$19,250.92
(1.07)44

2012PearsonEducation,Inc.PublishingasPrenticeHall
33Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
Evaluate:
Eventhoughthecashflowsarealittleunusual(anannuitystartingwellintothefuture),wecan
stillvaluethembycombiningthePVofannuityandPVofaFVtool.Thetotalvaluetoyou
todayofSocialSecurityspromiseislessthan$20,000.

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams34
*16. Plan:Clearly,Mr.Rodriguezscontractiscomplex,callingforpaymentsovermanyyears.
AssumethatanappropriatediscountrateforARodtoapplytothecontractpaymentsis
7%peryear.
a. Calculatethetruepromisedpaymentsunderthiscontract,includingthedeferredpayments
withinterest.
b. Drawatimelineofallofthepayments.
c. Calculatethepresentvalueofthecontract.
d. Comparethepresentvalueofthecontracttothequotedvalueof$252million.Whatexplains
thedifference?
Execute:DeterminethePVofeachofthepromisedpaymentsdiscountedtothepresentat7%.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

$18M 19M 19M 19M 21M 19M 23M 27M 27M 27M

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

6.7196M 5.3757M 4.0317M 4.0317M 4.0317M 4.0317M 4.0317M 4.0317M 4.0317M 4.0317M

ThePVofthepromisedcashflowsis$165.77million.

Evaluate:ThePVofthecontractismuchlessthan$252million.The$252millionvaluedoes
notdiscountthefuturecashflowsoradjustdeferredpaymentsforaccruedinterest.

*17. a.
0 1 2 3 43


5000 5000 5000 5000

Theamountintheretirementaccountin43yearswouldbe:

5000
FV43 ((1.10)43 1)
0.10
$2,962,003.46

N I/Y PV PMT FV ExcelFormula


Given: 43 10.00% 0.00 5000
SolveforFV: 2,962,003.46 FV(0.1,43,5000,0)

2012PearsonEducation,Inc.PublishingasPrenticeHall
35Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
b. Tosolveforthelumpsumamounttoday,findthePVofthe$2,962,003.46.

2,962,003.46
PV
(1.10)43
$49,169.99

N I/Y PV PMT FV ExcelFormula


Given: 43 10.00% 0 2,962,003
SolveforPV: (49,169.99) PV(0.1,43,0,2962003.46)
c.
0 1 2 3 20


2,962,003.46 C C C C
Solvefortheannuitycashflowthat,after20years,exactlyequalsthestartingvalueofthe
account.

2,962,003.46
C
1 1
1
0.10 1.10 20
347,915.81

N I/Y PV PMT FV ExcelFormula


Given: 20.00 0.10 2,962,003.46 0.00
SolveforPMT: 347,915.81 PMT(0.1,20,2962003.46,0)

d.
0 1 2 3 N


2,962,003.46 300,000 300,000 300,000 300,000
WewanttosolveforN,whichisthelengthoftimeinwhichthePVofannualpaymentsof
$300,000willequal$2,962,003.46.SettingupthePVofanannuityformulaandsolvingforN:

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams36
300,000 1
1 2,962,003.46
0.10 1.10 N
1 1 2,962,003.46 0.10
0.9873345
1.10 N 300,000
1
1 0.9873345 0.0126655
1.10 N
1.10 N 78.95456
Log(78.95456)
N 45.84
Log(1.10)

e. Ifwecanonlyinvest$1000peryear,thensetupthePVformulausing$1millionastheFV
and$1000astheannuitypayment.

1000 1
1 1,000,000
r (1 r )43
Tosolveforr,wecaneitherguessorusetheannuitycalculator.Youcancheckandseethat
r11.74291%solvesthisequation.Sotherequiredrateofreturnmustbe11.74291%.

N I/Y PV PMT FV ExcelFormula


Given: 43 0.00 1000 1,000,000
SolveforRate: 11.74291% RATE(43,1000,0,1000000)

18. Plan:Thebequestisaperpetuitygrowingataconstantrate.Thebequestisidenticaltoafirm
thatpaysadividendthatgrowsforeverataconstantrate.Wecanusetheconstantdividend
growthmodeltodeterminethevalueofthebequest.

Execute:
a.
0 1 2 3

1000 1000(1.08) 1000(1.08)2

UsingtheformulaforthePVofagrowingperpetuitygives

1000
PV
0.12 0.08
25,000

whichisthevaluetodayofthebequest.
b.
1 2 3 4
0 1 2 3

2012PearsonEducation,Inc.PublishingasPrenticeHall
37Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
1000(1.08) 1000(1.08)2 1000(1.08)3

UsingtheformulaforthePVofagrowingperpetuitygives:

1000(1.08)
PV
0.12 0.08
27,000

whichisthevalueofthebequestafterthefirstpaymentismade.

Evaluate:Thebequestisworth$25,000todayandwillbeworth$27,000in1yearstime.

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams38
*19. Plan:Themachinewillproduceaseriesofsavingsthataregrowingataconstantrate.Therate
ofgrowthisnegative,buttheconstantgrowthmodelcanstillbeused.

Execute:Thetimelineforthesavingwouldlookasfollows:

0 1 2 3

1000 1000(10.02) 1000(10.02)2

Wemustvalueagrowingperpetuitywithanegativegrowthrateof0.02:

1000
PV
0.05 ( 0.02)
$14,285.71

Evaluate:Thevalueofthesavingsproducedbythemachineisworth$14,285.71today.

20. Plan:Nobelsbequestisaperpetuity.Thetotalamountis5$45,000$225,000.Withacash
flowof$225,000andaninterestrateof7%peryear,wecanuseEq.4.4tosolveforthetotal
amounthewouldneedtousetoendowtheprizes.Inpart(b),wewillneedtousetheformula
foragrowingperpetuity(Eq.4.7)tofindthenewvaluehewouldneedtoleave.Finally,inpart
(c),wecanusetheFVequation(Eq.4.1)tosolveforthefuturevaluehisdescendantswould
havehadiftheyhadkeptthemoneyandinvesteditat7%peryear.
a. Inordertoendowaperpetuityof$225,000peryearwitha7%interestrateperyear,he
wouldneedtoleave$225,000/0.07$3,214,285.71.
b. Inordertoendowagrowingperpetuitywithaninterestrateof7%andagrowthrateof4%
andaninitialcashflowof$225,000,hewouldhavetoleave:
CF1 225,000
PV 7,500,000
r g 0.07 0.04

c. FVPV(1r)n7,500,000(1.07)118$21,996,168,112

Evaluate:
TheprizesthatbearNobelsnamewereveryexpensivetoendow$3millionwasanenormous
sumin1896.However,Nobelsendowmenthasbeenabletogenerateenoughinteresteachyear
tofundtheprizes,whichnowhaveacashawardofapproximately$1,500,000each!

21. Plan:Thedrugwillproduce17yearsofcashflowsthatwillgrowat5%annually.Thevalueof
thisstreamofcashflowstodaymustbedetermined.Wecanusetheformulaforagrowing
annuity(Eq.4.8)orExceltosolvethis.C2,r0.10,g0.05,N17

1 1.05
17

Execute: PV 2 1 21.86
0.10 0.05 1.10

2012PearsonEducation,Inc.PublishingasPrenticeHall
39Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
Sincethecashflowsfromthisinvestmentwillcontinuefor17years,wedecidedtosolveforthe
NetPresentValuebyusingtheNPVfunctioninExcel.Thisisshownbelow.The17cashflows
arepresentedincolumnsC,D,S.Theinitialcashflowof$2MispresentedincellC8and
eachsubsequentcashflowgrowsat5%until$4.365749Mispresentedinyear17incellS8.
(NotethatcolumnsGthroughQarenotpresented.)TheNPVoftheprojectiscalculatedusing
theNPVformula NPV(C3,C8:S8)incellB10.TheNPVofthefuturecashflowsis$21.86M.

A B C D E F R S
1
2 1+g 1.05
3 r 0.1
4
5
6 T 0 1 2 3 4 16 17
7
8 2 2.1 2.205 2.31525 4.157856 4.365749
9
10 NPV $21.86
11
12 EXCELNPVFORMULANPV(C3,C8:S8)
13

Evaluate:Thevaluetodayofthecashflowsproducedbythedrugoverthenext17yearsis
$21.86million.Becausethecashflowsareexpectedtogrowataconstantrate,wecanusethe
growingannuityformulaasashortcut.

22. Plan:Yourrichauntispromisingyouaseriesofcashflowsoverthenext20years.Youmust
determinethevalueofthosecashflowstoday.ThisisagrowingannuityandwecanuseEq.4.8
tosolveit,orwecanalsosolveitinExcel.C5,r0.03,g0.05andN20

1 1.03
20

Execute: PV 5 1
1.05 79.82

.05 .03

Sincethecashflowsfromthisinvestmentwillcontinuefor20years,wedecidedtosolveforthe
NetPresentValuebyusingtheNPVfunctioninExcel.Thisisshownbelow.The20cashflows
arepresentedincolumnsC,D,V.Theinitialcashflowof$5000ispresentedincellC8and
eachsubsequentcashflowgrowsat3%until$8767.53ispresentedinyear20incellV8.(Note
thatcolumnsGthroughRarenotpresented.)TheNPVoftheprojectiscalculatedusingthe
NPVformula NPV(C3,C8:V8)incellB10.TheNPVofthefuturecashflowsis$79,824.

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams40

A B C D E S T U V
1
2 1+g 1.03
3 r 0.05
4
5
6 T 0 1 2 3 17 18 19 20
7
8.51216
8 5 5.15 5.3045 8.023532 8.264238 5 8.76753
9
10 NPV $79.82
11
12 EXCELNPVFORMULANPV(C3,C8:V8)
13

Evaluate:Becauseyourauntwillbeincreasinghergiveeachyearataconstantrate,wecanuse
thegrowingperpetuityformulaasashortcuttovaluethestreamofcashflows.Hergiftisquite
generous:itisequivalenttogivingyoualmost$80,000today!

23. Plan:Thisproblemisaskingustosolvefortherateofreturn(r).Becausetherearenorecurring
payments,wecanuseEq.4.1torepresenttheproblemandthenjustsolvealgebraicallyforr.
WehaveFV100,PV50,n10.

Execute:
FVPV(1r)n
1

100 10
10050(1r) ,so r
10
1 0.072,or7.2%
50

Evaluate:
Theimplicitreturnweearnedonthesavingsbondwas7.2%.Ourmoneydoubledin10years,
whichbytheruleof72meantthatweearnedabout72/10=7.2%andourcalculationconfirmed
that.

24. Plan:Thisproblemisagainaskingustosolveforr.Wewillrepresenttheinvestmentwith
Eq.4.1andsolveforr.WehavePV1000,FV5000,n10.Thesecondpartoftheproblem
asksustochangetherateofreturngoingforwardandcalculatetheFVinanother10years.

Execute:
a. FV=PV(1+r)n
1

5000 10
50001000(1r) ,so r
10
1 0.1746,or17.46%
1000
b. FV5000(1.15)10$20,227.79

2012PearsonEducation,Inc.PublishingasPrenticeHall
41Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
25. Plan:DrawatimelineanddeterminetheIRRoftheinvestment.

Execute:

0 1

5000 6000
IRRistherthatsolves:

6000 6000
5000 1 20%
1 r 5000

Evaluate:Youaremakinga20%IRRonthisinvestment.

26. Plan:Drawatimelinetodemonstratewhenthecashflowswilloccur.Thensolvetheproblem
todeterminethepaymentsyouwillreceive.

Execute:
0 1 2 3

1000 C C C
C
P C P r 1000 0.05 $50
r

Evaluate:Youwillreceive$50peryearintoperpetuity.
27. Plan:Drawatimelinetodeterminewhenthecashflowsoccur.Solvetheproblemtodetermine
theannualpayments.

Timeline(fromtheperspectiveofthebank):

Execute:
0 1 2 3 30


300,000 C C C C
300,000
C $24,176
1 1
1
0.07 1.0730
whichistheannualpayment.

N I/Y PV PMT FV ExcelFormula


Given: 30 7.00% 300,000.00 0
SolveforPMT: $24,175.92 PMT(0.07,30,300000,0)

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams42
Evaluate:Youwillhavetopaythebank$24,176peryearfor30yearsinmortgagepayments.

2012PearsonEducation,Inc.PublishingasPrenticeHall
43Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
*28. Plan:Drawatimelinetodemonstratewhenthecashflowswilloccur.Determinetheannual
payments.

Execute:
0 2 4 6 20
0 1 2 3 10


500,00 C C C C

Thiscashflowstreamisanannuity.First,calculatethe2yearinterestrate:The1yearrateis
4%,and$1todaywillbeworth(1.04)21.0816in2years,sothe2yearinterestrateis8.16%.
Usingtheequationforanannuitypayment:

50,000
C
1 1
1 10
0.0816 (1.0816)
$7505.34

whichisthepaymentyoumustmakeevery2years.

N I/Y PV PMT FV ExcelFormula


Given: 10 8.16% 50,000.00 0
SolveforPMT: $7,505.34 PMT(0.0816,10,50000,0)

Evaluate:Youmustpaytheartdealer$7505.34every2yearsfor20years.

*29. Plan:Drawatimelinetodeterminewhenthecashflowsoccur.Timeline(whereXistheballoon
payment):
0 1 2 3 30


300,000 23,500 23,500 23,500 23,500X

NotethatthePVoftheloanpaymentsmustbeequaltotheamountborrowed.

Execute:

23,500 1 X
300,000 1 30

0.07 1.07 (1.07)30

SolvingforX:

23,500 1
X 300,000 1 (1.07)
30

0.07 1.0730
$63,848

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams44

N I/Y PV PMT FV ExcelFormula


Given: 30 7.00% 23,500 0
SolveforPV: 291,612.47 PV(0.07,30,23500,0)

Thepresentvalueoftheannuityis$291,612.47,whichis$8387.53lessthanthe$300,000.00.
Tomakeupforthisshortfallwithaballoonpaymentinyear30wouldrequireapaymentof
$63,848.02.

N I/Y PV PMT FV ExcelFormula


Given: 30 7.00% 8387.53 0
SolveforFV: (63,848.02) FV(0.07,30,0,8387.53)

Evaluate:Attheendof30yearsyouwouldhavetomakea$63,848single(balloon)paymentto
thebank.

*30. Plan:Drawatimelinetodemonstratewhenthecashflowsoccur.Weknowthatyouintendto
fundyourretirementwithaseriesofannuitypaymentsandthefuturevalueofthatannuityis
$2million.
22 23 24 25 65
0 1 2 3 43


C C C C C

Execute:FV$2million.

ThePVofthecashflowsmustequalthePVof$2millionin43years.Thecashflowsconsistof
a43yearannuity,plusthecontributiontoday,sothePVis:

C 1
PV 1 C
0.05 1.05 43
ThePVof$2millionin43yearsis:

2,000,000
$245,408.80
(1.05)43

N I/Y PV PMT FV ExcelFormula


Given: 43 5.00% 0 2,000,000
SolveforPV: (245,408.80) PV(0.05,43,0,2000000)

2012PearsonEducation,Inc.PublishingasPrenticeHall
45Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
Settingtheseequalgives

C 1
1 C 245,408.80
0.05 (1.05)43
245,408.80
C $13,232.50
1 1
1 1
0.05 (1.05)43

Weneed$245,408.80todaytohave$2,000,000in43years.Ifwedonothave$245,408.80
today,butwishtomake44equalpayments(thefirstpaymentistoday,makingthepayments
anannuitydue)thentherelevantExcelcommandis:

PMT(rate,nper,pv,(fv),typePMT(.05,44,245,408.80,0,1)13,232.50

Typeissetequalto1foranannuitydueasopposedtoanordinaryannuity.

Evaluate:Youwouldhavetoputaside$13,232.50annuallytohavethe$2millionyouwishto
haveinretirement.

31. Plan:Thisproblemisaskingyoutosolveforn.Youcandothismathematicallyusinglogs,or
withafinancialcalculatororExcel.Becausetheproblemhappenstobeaskinghowlongitwill
takeourmoneytodouble,wecanestimatetheanswerusingtheruleof72:72/107.2,sothe
answerwillbeapproximately7.2years.

20000
ln
Execute: 10000
N 7.27
ln 1.10

UsingafinancialcalculatororExcel:

10 10000 0 20000
7.27
ExcelFormula:NPER(RATE,PMT,PV,FV)
NPER(0.10,0,10000,20000)

Evaluate:
Ifyoucanearn10%peryearonthe$10,000,itwilldoubleto$20,000in7.27years.

32. Plan:Drawthetimelineanddeterminetheinterestratethebankispayingyou.

Execute:
0 1 2 3

1000 100 100 100

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams46
100
Thepaymentsareaperpetuity,so PV .
r

SettingtheNPVofthecashflowstreamequalto0andsolvingforrgivestheIRR:

100 100
NPV 0 1000 r 10%
r 1000
SotheIRRis10%.

Evaluate:Thebankispayingyou10%onyourdeposit.

*33. Plan:Drawatimelinetoshowwhenthecashflowsoccur.Thendeterminehowlongtheplant
willbeinproduction.AlsoestimatetheNPVoftheprojectandhencewhetherornotitshould
bebuilt.

Execute:
0 1 2 N


10,000,000 1,000,000 1,000,000 1,000,000
50,000 50,000(1.05) 50,000(1.05)N1
Theplantwillshutdownwhen:

1,000,000 50,000(1.05) N 1 0
1,000,000
(1.05) N 1 20
50,000
( N 1) log(1.05) log(20)
log(20)
N 1 62.4
log(1.05)

Sothelastyearofproductionwillbeinyear62.

WenowbuildanExcelspreadsheetwiththecashflowstothe62years.

A B C D E F G BJ BK BL
1
2 G 1.05
3 R 0.06
4
5
6T 0 1 2 3 4 5 60 61 62
7
8 10000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000
9 50000 52500 55125 57881.3 60775.3 889485 933959 980657
10 ($10,000,000.00) 950000 947500 944875 942118.8 939224.7 110515 66040.71 19342.74
11
12 NP $3,995,073.97

2012PearsonEducation,Inc.PublishingasPrenticeHall
47Berk/DeMarzo/HarfordFundamentalsofCorporateFinance,SecondEdition
V
13 EXCELNPVFORMULAB10NPV(C3,C11:BL11)

TheNetPresentValueoftheprojectiscomputedincellB12.

Evaluate:So, theNPV 13,995,074 10,000 $3,995,074, andyoushouldbuildit.

*34. Plan:Drawatimelinetoshowwhenthecashflowswilloccur.Thendeterminehowmuchyou
willhavetoputintotheretirementplanannuallytomeetyourgoal.

Execute:
22 23 24 65 66 67 100
0 1 2 43 44 45 78

C C C 100 100 100

ThePVofthecostsmustequalthePVofthebenefits,sobeginbydividingtheproblemintotwo
parts:thecostsandthebenefits.

Costs:Thecostsarethecontributions,a43yearannuitywiththefirstpaymentin1year:

C 1
PVcosts 1
0.07 (1.07)43

Benefits:Thebenefitsarethepayoutsafterretirement,a35yearannuitypaying$100,000
peryearwiththefirstpayment44yearsfromtoday.Thevalueofthisannuityinyear43is:

100,000 1
PV43 1
0.07 (1.07)35

N I/Y PV PMT FV ExcelFormula


Given: 35 7.00% 100000 0
SolveforPV: (1,294,767.23) PV(0.07,35,100000,0)

Thevaluetodayisjustthediscountedvaluein43years:

PV43
PVbenefits
(1.07)43
100,000 1
43
1
0.07(1.07) (1.07)35
70,581.24

2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4TimeValueofMoney:ValuingCashFlowStreams48
SincethePVofthecostsmustequalthePVofthebenefits(orequivalently,theNPVofthecash
flowmustbezero):

C 1
70,581.24 1
0.07 (1.07)43

N I/Y PV PMT FV ExcelFormula


Given: 43 7.00% 0 1,294,767
SolveforPV: (70,581.24) PV(0.07,43,0,1294767.23)

SolvingforCgives

70,581.24 0.07
C
1
1
(1.07)43
5225.55

N I/Y PV PMT FV ExcelFormula


Given: 43 7.00% 70,581.24 0
SolveforPMT: (5,226) PMT(0.07,43,70581.24,0)

Evaluate:Youwillhavetoinvest$5225.55annuallyintotheretirementplantomeetyourgoal.

2012PearsonEducation,Inc.PublishingasPrenticeHall