Chapter 2

Principles of
Corporate Finance
How to Calculate
Present Values



Prepared by

Mohammad Aqabneh
Sameeh Swaitti
2-2
Topics Covered
Future Values and Present Values
Perpetuities and Annuities
Growing Perpetuities and Annuities
How Interest Is Paid and Quoted
2-3
Present and Future Value

The money has a time value and that
constitutes the most basic principle of
finance :
( a dollar today is worth more than a dollar
tomorrow )

2-4
Present and Future Value
Present Value
Value today of a
future cash
flow.
Future Value
Amount to which an
investment will grow
after earning interest
2-5
Future Values
Future Value of $100 = FV


FV r
t
= + $100 ( ) 1
2-6
Future Values
Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?


82 . 133 $ ) 06 . 1 ( 100 $
5
= + = FV
2-7
Future Values
FV r
t
= + $100 ( ) 1
Example - FV
What is the future value of $400,000 if interest is
compounded annually at a rate of 5% for one year?

000 , 420 $ ) 05 . 1 ( 000 , 400 $
1
= + = FV
2-8
Present Value
1
factor discount = PV
PV = Value Present
C
2-9
Present Value
Discount Factor = DF = PV of $1





Discount Factors can be used to compute the present value of
any cash flow.
DF
r
t
=
+
1
1 ( )
Discount Factor
Present value of
a $1 future
payment.
2-10
Calculating the Present Value of an
Investment Opportunity
Suppose you own a small company that is contemplating
construction of an office block. The total cost of buying the
land and constructing the building is $370,000, but your real
estate adviser forecasts a shortage of office space a year from
now and predicts that you will be able sell the building for
$420,000.
Suppose that the rate of interest on U.S. government securities
is r 5% per year. Then, the present value of your office
building is:


2-11
Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C
0
= 370,000
Sale price in Year 1 = C
1
= 420,000

Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%

2-12
Valuing an Office Building
Step 3: Discount future cash flows



Step 4: Go ahead if PV of payoff exceeds investment

000 400
05 1
000 420
1
1
,
) . (
,
) ( + +r
C
PV
000 30
000 370 000 400
,
, , NPV
=
=
2-13
Net Present Value
r
C
+
+
1
C = NPV
investment required - PV = NPV
1
0
2-14
Risk and Present Value
Higher risk projects require a higher rate of
return
Higher required rates of return cause lower
PVs
000 , 400
.05 1
420,000
PV
5% at $420,000 C of PV
1
=
+
=
=
2-15
Risk and Present Value
000 , 400
.05 1
420,000
PV
5% at $420,000 C of PV
1
=
+
=
=
000 , 375
.12 1
420,000
PV
12% at $420,000 C of PV
1
=
+
=
=
2-16
Net Present Value Rule
Accept investments that have positive net
present value
Example
Use the original example. Should we accept the
project given a 10% expected return?


000 , 30 $
1.05
420,000
+ -370,000 = NPV =
2-17
Rate of Return Rule
Accept investments that offer rates of return
in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment
opportunity is 12%. Should we do the project?
13.5% or .135
370,000
370,000 420,000
investment
profit
Return =

= =
2-18
Multiple Cash Flows
For multiple periods we have the
Discounted Cash Flow (DCF) formula

t
t
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 (
0
....
2
2
1
1
+ + +
+ + + =

=
+
+ =
T
t
r
C
t
t
C NPV
1
) 1 (
0 0
2-19
Present Values When There Are Multiple Cash
Flows
Example :
Your real estate adviser has come back with some
revised forecasts. He suggests that you rent out the
building for two years at $20,000 a year, and predicts
that at the end of that time you will be able to sell the
building for $400,000.
Thus there are now two future cash flows :
1. a cash flow of C1 $20,000 at the end of one year.
2. cash flow of C2 (20,000 +400,000) = $420,000 at the
end of the second year.
2-20
Present Values with Multiple Cash Flows
The present value of your property development is equal to the
present value of C1 plus the present value of C2.

( )
( )
300 , 17 $ 000 , 370 700 , 352
700 , 352 $ 334800 900 , 17
12 . 1
420000
12 . 1
20000
1
2
1
1
2
2
= =
= + = + =
+
+
+
=
NPV
r
c
r
c
pv
Sorry, but your office building is now worth less than it
costs. NPV is negative:

2-21
Net Present Values
Present Value
Year 0

20,000/1.12
420,000/1.12
2
Total



= $17,900
= $334,800
= - $17,300
$20,000
- $370,000
Year
0 1 2
$ 420,000
-$370,000
2-22
Short Cuts
Sometimes there are shortcuts that make it
very easy to calculate the present value of
an asset that pays off in different periods.
These tools allow us to cut through the
calculations quickly.
2-23
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
PV
C
r =
=
lue present va
flow cash
Return
2-24
Short Cuts
r
C
PV
1
0
rate discount
flow cash
Flow Cash of PV
=
=
2-25
Present Values
Example
What is the present value of $1 billion every year, for all
eternity, if you estimate the perpetual discount rate to be
10%??



billion 10 $
10 . 0
bil $1
= = PV
2-26
Present Values
Example - continued
What if the investment does not start making money for 3
years?



( ) billion 51 . 7 $
3
1.10
1
10 . 0
bil $1
= = PV
2-27
Short Cuts
Annuity - An asset that pays a fixed sum each year for
a specified number of years.
r
C
Perpetuity (first
payment in year 1)
Perpetuity (first payment
in year t + 1)
Annuity from year
1 to year t
Asset Year of Payment
1 2..t t + 1
Present Value
t
r r
C
) 1 (
1
+
|
.
|

\
|
|
|
.
|

\
|
+
|
.
|

\
|

|
.
|

\
|
t
r r
C
r
C
) 1 (
1
2-28
Example
Tiburon Autos offers you easy payments of $5,000 per year, at the end
of each year for 5 years. If interest rates are 7%, per year, what is the
cost of the car?
Present Values
5,000
Year
0 1 2 3 4 5
5,000 5,000 5,000 5,000
( )
( )
( )
( )
20,501 NPV Total
565 , 3 07 . 1 / 000 , 5
814 , 3 07 . 1 / 000 , 5
081 , 4 07 . 1 / 000 , 5
367 , 4 07 . 1 / 000 , 5
673 , 4 07 . 1 / 000 , 5
5
4
3
2
=
=
=
=
=
=
Present Value
at year 0
2-29
Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.
( )
(

+
=
t
r r
r
C
1
1 1
annuity of PV
2-30
Annuity Short Cut
Example
You agree to lease a car for 4 years at $300 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of capital
is 0.5% per month, what is the cost of the lease?
2-31
Annuity Short Cut
Example - continued
You agree to lease a car for 4 years at $300 per
month. You are not required to pay any money up
front or at the end of your agreement. If your
opportunity cost of capital is 0.5% per month,
what is the cost of the lease?
( )
10 . 774 , 12 $
005 . 1 005 .
1
005 .
1
300 Cost Lease
48
=
(

+
=
Cost
2-32
Annuity Short Cut
Example
The state lottery advertises a jackpot prize of $295.7
million, paid in 25 installments over 25 years of $11.828
million per year, at the end of each year. If interest rates
are 5.9% what is the true value of the lottery prize?
( )
000 , 600 , 152 $
059 . 1 059 .
1
059 .
1
828 . 11 Value Lottery
25
=
(

+
=
Value
2-33
Amortizing loan
$1000 loan for 4 years with interest 10% and
annual payments:
c= 315.47

( )
( )
47 . 315 $
1699 . 3
1000
1 . 1 1 .
1
1 .
1
1000
1
1 1
4
= =
=
+
=
c
r r
r
c pv
t
2-34
Regular Annuities
(amortizing )
year Beginning of year
Balance
Year-end
interest on
balance
Total year-end
payment
Amortizing
of loan
End-of-year
Balance
1 1000.00 100 315.47 215.47 784.53
2 784.53 78.45 315.47 237.02 547.51
3 547.51 54.75 315.47 260.72 286.79
4 286.79 28.68 315.47 286.79 0
2-35
PV Annuities Due

When we used the annuity formula to value the lottery prize in
Example 2.3, we presupposed that the first payment was made
at the end of one year. In fact, the first of the 25 yearly
payments was made immediately. How does this change the
value of the prize?
If we discount each cash flow by one less year, the present
value is increased by the multiple (1+ r ). In the case of the
lottery prize the value becomes :
152.6 * (1 + r ) = 152.6 * 1.059= $161.6 million.

( )
( ) r
r r
r
c pv
t
+
(

+
= 1
1
1 1
2-36
FV Annuity Short Cut
Future Value of an Annuity The future value of
an asset that pays a fixed sum each year for a
specified number of years.
( )
(

+
=
r
r
C
t
1 1
annuity of FV
2-37
Annuity Short Cut
Example
What is the future value of $20,000 paid at the end of each
of the following 5 years, assuming your investment returns
8% per year?
( )
332 , 117 $
08 .
1 08 . 1
000 , 20 FV
5
=
(

+
=
2-38
Growing Perpetuities

You now know how to value level streams of
cash flows, but you often need to value a
stream of cash flows that grows at a constant
rate. For example, think back to your plans to
donate $10 billion to fight malaria and other
infectious diseases. Unfortunately, you made
no allowance for the growth in salaries and
other costs, which will probably average about
4% a year starting in year 1.
2-39
Constant Growth Perpetuity
g r
C
PV

=
1
0
g = the annual growth
rate of the cash flow
2-40
Constant Growth Perpetuity
g r
C
PV

=
1
0
NOTE: This formula can be
used to value a perpetuity at
any point in time.
g r
C
PV
t
t

=
+1
2-41
Constant Growth Perpetuity
Example
What is the present value of $1 billion paid at the end of
every year in perpetuity, assuming a rate of return of 10%
and a constant growth rate of 4%?
billion 667 . 16 $
04 . 10 .
1
0
=

= PV
2-42
Perpetuities
A three-year stream of cash flows that grows at
the rate g is equal to the difference between two
growing perpetuities.
2-43
Useful Shortcut
2-44
Growing Annuities
You are contemplating membership in the St. Swithins and
Ancient Golf Club. The annual membership dues for the
coming year are $5,000, but you can make a single payment of
$12,750, which will provide you with membership for the next
three years. In each case no payments are due until the end of
the first year. Which is the better deal , suppose that growing
rate =6% and the interest rate =10%?
In our golf club example, the present value of the three annual
membership dues would be:

( )
( )
( )
( )
( )
13146 $ 5000 $ 629 . 2
5000 $
10 . 1
06 . 1
06 . 10 .
1
06 . 10 .
1
1
1 1 1
3
3
= =

=
+
+

=
t
t
r
g
g r g r
pv
2-45
Effective Interest Rates
Annual Percentage Rate - Interest rate that is
annualized using simple interest.
Effective Annual Interest Rate - Interest rate
that is annualized using compound interest.
2-46
How Interest Is Paid and Quoted
we have assumed that cash flows occur only at the end of each
year (annual percentage rate APR). This is sometimes the case,
but some firms pays on semiannually or monthly base, here we
need to differ between the quoted and effective interest rate ,
there is no difference between them if they calculated yearly.

12% with interest to be paid monthly. This means that each
month you need to pay one-twelfth of the annual rate, that
is, 12/12= 1% a month. Thus the bank is quoting a rate of
12%, but the effective annual interest rate on your loan is
1.01 - 1 = .1268, or 12.68%




2-47
In general, if you invest $1 at a rate of r per year compounded
m times a year, your investment at the end of the year will be
worth [1 + ( r / m )]
the effective interest rate is : [1+ ( r / m )] - 1.

Suppose a bank offers you an automobile loan at an annual
percentage rate, or APR, of 12% with interest to be paid monthly.
In our automobile loan example r = .12 and
m =12. So the effective annual interest rate was
[1 .12/12] - 1 = .1268, or 12.68%.

m t
m
r
m
=

|
.
|

\
|
+ 1 1
2-48
Effective Interest Rates
example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?


2-49
Effective Interest Rates
example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?


12.00% or .12 = 12 x .01 = APR
12.68% or .1268 = 1 - .01) + (1 = EAR
r = 1 - .01) + (1 = EAR
12
12
2-50
50
Compounding
Compounding refers to the frequency with
which interest is computed and added to the
principal balance

The more frequent the compounding, the higher
the interest earned
2-51
Continuous Intervals
Continuous compounding results
when there is an infinite number of
compounding periods

2-52
Discrete compounding
Mathematical adjustment for discrete
compounding:

(1 / )
annual interest rate
number of compounding periods per year
time in years
mt
FV PV R m
R
m
t
= +
=
=
=
2-53
Continuous Intervals (contd)
Mathematical equation for continuous
compounding:

2.71828
Rt
FV PVe
e
=
=
2-54
Continuous Intervals (contd)
Example

Your bank pays you 3 percent per year on your savings
account. You just deposited $100.00 in your savings
account.

What is the future value of the $100.00 in one year if
interest is compounded quarterly? If interest is
compounded continuously?






2-55
Continuous Intervals (contd)
Example (contd)

Solution: For quarterly compounding:







4
(1 / )
$100.00(1 0.03/ 4)
$103.03
mt
FV PV R m = +
= +
=
2-56
Continuous Intervals (contd)
Example (contd)

Solution (contd): For continuous compounding:







0.03
$100.00
$103.05
Rt
FV PVe
e
=
=
=
2-57
Continuous Intervals (contd)
2-58
suppose that you have thought again about your donation
and have decided to fund a vaccination program in
emerging countries, which will cost $1 billion a year,
starting immediately, and spread evenly over 20 years.
Previously, we used the annually compounded rate of 10%


2-59




2-60

2-61
1
2-62
2
A factory costs $800,000. You reckon that it will produce
an inflow after operating costs of $170,000 a year for 10
years. If the opportunity cost of capital is 14%, what is
the net present value of the factory? What will the factory
be worth at the end of five years?
2-63
2