FINE 2000 Discounted Cash Flow Valuation

Anthony Mayadunne
Chapter 6

Chapter Outline

6-2

Future and Present Values of Multiple Cash Flows

Valuing Level Cash Flows: Annuities and Perpetuities
Comparing Rates: The Effect of Compounding
Loan Types and Mortgages
Summary and Conclusions

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Multiple Cash Flows PV

Example 1

You are offered an investment that will pay you $200 in one year,
$400 the next year, $600 the year after, and $800 at the end of the
following year. You can earn 12% on similar investments. How
much is this investment worth today?

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Multiple Cash Flows

0

200

400

600

800

178.57
318.88
427.07
508.41
1432.93

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Multiple Cash Flows - PV Example 1

continued

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Find the PV of each cash flow and add them

o

Formula Approach

6-5

Year 1 CF: 200 / (1.12)1 = 178.57

Year 2 CF: 400 / (1.12)2 = 318.88
Year 3 CF: 600 / (1.12)3 = 427.07
Year 4 CF: 800 / (1.12)4 = 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93

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Multiple Cash Flows - PV Example 1

continued
o

Calculator Approach

6-6

Year 1 CF: N = 1; I/Y = 12; FV = 200; CPT PV = -178.57

Year 2 CF: N = 2; I/Y = 12; FV = 400; CPT PV = -318.88
Year 3 CF: N = 3; I/Y = 12; FV = 600; CPT PV = -427.07
Year 4 CF: N = 4; I/Y = 12; FV = 800; CPT PV = - 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93

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Multiple Uneven Cash Flows Using

the Calculator

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Another way to use the financial calculator for uneven

cash flows is to use the cash flow keys
o

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Texas Instruments BA-II Plus

Press CF and enter the cash flows beginning with year 0
You have to press the Enter key for each cash flow
Use the down arrow key to move to the next cash flow
The F is the number of times a given cash flow occurs in
consecutive years
Use the NPV key to compute the present value by entering the
interest rate for I, pressing the down arrow and then compute
Clear the cash flow keys by pressing CF and then CLR Work
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Saving For Retirement

You are offered the opportunity to put some money away for
retirement. You will receive five annual payments of $25,000 each
beginning in 40 years. How much would you be willing to invest
today if you desire an interest rate of 12%?

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Saving For Retirement Timeline

0 1 2

39

0 0 0

40

41

42

43

44

25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)

The cash flows years 1 39 are 0 (C01 = 0; F01 = 39)
The cash flows years 40 44 are 25,000 (C02 = 25,000; F02 = 5)

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Saving For Retirement continued

Calculator Approach
o

Use cash flow keys:

CF; CF0 = 0; C01 = 0; F01 = 39; C02 = 25000; F02 = 5; NPV;

I = 12; CPT NPV = 1084.71

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Quick Quiz Part I

Suppose you are looking at the following possible cash flows: Year 1
CF = $100; Years 2 and 3 CFs = $200; Years 4 and 5 CFs = $300.
The required discount rate is 7%

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What is the value of the cash flows at year 5?

What is the value of the cash flows today?
What is the value of the cash flows at year 3?

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Perpetuities
An investment which pays off at
regular intervals forforever! In
perpetuity!

Initial purchase of the bond

The bond earns interest, which is
paid to owner at regular intervals

Famous consol bond was first

issued by British Government in
1751and still continue to exist!

http://www.immediateannuities.com/annuitymuseum/images/docs/10129-f-full-mid.jpg

How does a Perpetuity work?

Cash payment = interest rate x present value of investment
Or
C = r x PV, from which we can calculate the present value of the
perpetuity..
PV = C/r
E.g. Philanthropist wishes to endow a chair in Finance, providing
$100,000/year forever. How much must she put aside if the interest
rate is 10%?
PV of endowment = C/r = $100,000/0.1 = $1,000,000

Finance 101 for worthy donors to UOIT.

First payment is at end of year 1. If the philanthropist wants the
payment to start immediately, she has to put up an extra $100,000 (for
now) in addition to the $1,000,000. So her total endowment will be
$1,100,000.
What happens if she wants to start the payments in 3 years? That
means that she needs to have a perpetuity of ($100,000/0.1) available
in 2017. What does she need to put aside in 2014 to make that possible?
To get the present value we need to discount 2017 endowment to 2014:
($100,000/0.1) x 1/(1+r)3 = $751,315.
In general, PV = (C/r) x [1/(1 + r)n] = C[1/r(1 + r)n] for a delayed annuity.

Annuities

http://www.edisonfinancial.com/Annuity%20Main%20Picture.jpg

Calculating an Annuity

So, the present value of an annuity that pays $C per time period for t time
periods is

1
1
C

t
r r (1 r )

Hitting the jackpot

In Las Vegas, a winner hits the jackpot advertised at a value of $9.37
million. However, the payments were in 25 annual instalments of
$374,800. What is the true present value of the jackpot, (assuming an
interest rate of 5%)?
Winner gets an annuity of $374,800 per year for 25 years. Its present
value is
PV = $374,800 x [(1/0.05) (1/0.05(1.05)25)] = $5,282,410
So true present value of the jackpot is $5,282, 410which is just over
half the advertised amount

Retiring in style sort of

You hope to retire at 70, and (optimistically) hope to live to 90, living
on $55,000/year. How much do you need to save by 70 to afford this
lifestyle? Assume interest rate of 7%.
When you get to 70, your savings will have to pay out $55,000/ year
for 20 years. So your savings need to be
PV = $55,000 x [(1/0.07) (1/0.07(1.07) 20)] = $582,670.78
So you need to have saved up a nest-egg of $582,670.78 by your 70 th
birthday

Buying a condo
You buy a condo ($150,000) with 25% down payment and the rest
financed by a bank mortgage at 1%/month for 25 years. What will be
your monthly payments?
Down payment = $150,000 x 0.25 = $37,500,
So, bank loan required is = $150,000 - $37,500 = $112,500.
If your monthly mortgage payment is $C, paid over (25 x 12 =) 300 months,
$112,500 = $C x [(1/0.01) (1/0.01(1.01)300)]
$C = $112,500 / [(1/0.01) (1/0.01(1.01)300)] = $1,184.88
So your monthly mortgage payments will be $ 1,184.88

Annuities Due
So far we have assumed that the annuities are paid out at the end of
each period. What happens if the first payment is due immediately?
We simply shift first payment to now, and calculate the value of the
remaining (t-1) payments.
For example, if Kangaroo Autos offered you a $10,000 car in 3 annual
payments of $4000 (payable at the end of each year). Is it a good deal?
What if the first $4000 payment was due now, and the subsequent two
payments due in the next 2 years?

Kangaroo financing

Calculating Annuities due starting now

Recall,
PV of annuity is = $C [(1/r) (1/r(1 + r)t)],
But if the first payment is made immediately, then there are
(t-1) payments left,
so the PV is now,
PV = $C + $C [(1/r) (1/r(1 + r)t-1)],

PV = $C x {1 + [(1/r) (1/r(1 + r)t-1)]}

Hitting the jackpot Part 2

In Las Vegas, a winner hits the jackpot advertised at a value of $9.37
million. However, the payments were in 25 annual instalments of
$374,800. What is the true present value of the jackpot, (assuming an
interest rate of 5%) if the first payment is made today?
Winner gets an annuity of $374,800 per year for 25 years. Its present
value is
PV

= $ 374, 800 + $374,800 x [(1/0.05) (1/0.05(1.05) 24)]

= $5,546,530.95

Calculating the Future Value of Annuities

In contrast to the calculating present value (e.g. of lottery winnings,
mortgages etc), what if we needed to calculate the future value of savings? If
we are making regular savings deposits to meet a nest-egg target, we need
to calculate not the present value, but rather the future value of
accumulated savings. Simple! We simply calculate the future value based on
the present value.
so the PV is now,
PV = $C [(1/r) (1/r(1 + r)t)], and future value of PV is PV x (1 + r)t
FV = $C [(1/r) (1/r(1 + r)t)] x (1 + r)t which works out to

FV = $C x [(1 + r)t 1]/r

Saving for retirement

Assuming you are 20 now, and plan to retire at 65. You are aiming to
have $500,000 in savings. If the interest rate is 10% per year, how
much should you put aside every year to meet that goal?

Say, you put aside $C each year for the next (65-20=) 45 years.
FV($500,000)

= $C x [(1 + 0.1)45 1]/0.1 = $C x 718.905

$C = $500,000/718.905 = $695.50
So you need to save $695.50 every year for the next 45 years to have a
nest egg of $500,000.

Annuities with a constant growth cash flow..

While we assumed that the cash flows ($C) will be the same for both
annuities and perpetuities, usually these cash flows grow at a constant
rate (to account for inflation, depreciation etc).
Simple case: An infinite stream of cash flows constantly growing
(growing perpetuity)
Typical case: A finite stream of cash flows that grow at a constant
rate, and terminate after a certain period.

Simple Case

A growing perpetuity with a constant growth rate of g has a PV that

can be shown as:
0

P
V

C(1+g)

C(1+g)

C(1+g)

PV of a growing
perpetuity =

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2012 McGrawHill Ryerson Ltd.

C1
r-g

Chapter 5 -27

Buying a condo as an investment(Part 1)

A condominium apartment as an investment generates $12,000 (rent
minus expenses) annually. This cash flow grows at 3% per year indefinitely.
If the interest rate is 8%, what is the present value of the cash flows?

PV = C1/(r g) = $12,000/(0.08 0.03) = $240,000

So, investing in a condo with $12,000 annual cash flows, assuming a
growth of 3%,and interest rate of 8%, gives a present value of its
future cash flows at $240,000.

Typical Case

A growing annuity with a growth rate of g has a PV that can be

shown as, which terminates at some time t:
0

P
V

C(1+g)

C(1+g)

C(1+g)

C1
1 g
PV of growing annuity
1
r g
1 r
2012 McGrawHill Ryerson Ltd.

Buying a condo as an investment(Part 2)

For the same condo generating $12,000 (rent minus expenses) annually
and growing at 3% per year, what is the present value of cash flows if it is
expected to have a life of 20 years (i.e. will be torn down after 20 years).
Assume interest of 8%.

PV = [$12,000/(0.08 -0.03)] x [1 (1.03/1.08) 20] = $147,000.50

So, investing in a condo with $12,000 annual cash flows, assuming a
growth of 3%,and interest rate of 8% over the 20 year life of the
condo, gives a present value of its future cash flows at $147,000.50.

Future value of the growing annuity

As before, the FV can be calculated, by simply multiplying the PV by (1 + r) t
i.e.

C1
1 g
PV of growing annuity
1
r g
1 r

(1 r ) t

So, for the condo example, the future value of the condo at the end of 20
years will be:
FV

= [$12,000/(0.08 -0.03)] x [1 (1.03/1.08)20] x (1+0.08)20

= $685,163

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4

Effective Annual Rate (EAR) 6.3

This is the actual rate paid (or received) after

accounting for compounding that occurs during
the year

If you want to compare two alternative

investments with different compounding
periods, you need to compute the EAR for both
investments and then compare the EARs.

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4

Annual Percentage Rate

This is the annual rate that is quoted by law

By definition APR = period rate times the
number of periods per year

Consequently, to get the period rate we rearrange

the APR equation:
o Period rate = APR / number of periods per year

You should NEVER divide the effective rate

(EAR) by the number of periods per year it will
NOT give you the period rate

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4

Computing APRs

What is the APR if the monthly rate is .5%?

o

What is the APR if the semiannual rate is .5%?

o

.5(2) = 1%

What is the monthly rate if the APR is 12% with

monthly compounding?
o
o

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.5(12) = 6%

12 / 12 = 1%
Can you divide the above APR by 2 to get the semiannual rate? NO!!! You
need an APR based on semiannual compounding to find the semiannual
rate.

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4

Things to Remember

You ALWAYS need to make sure that the interest rate and the time
period match.

If you are looking at annual periods, you

need an annual rate.
o If you are looking at monthly periods, you
need a monthly rate.
o

If you have an APR based on monthly compounding, you have to use

monthly periods for lump sums, or adjust the interest rate
appropriately if you have payments other than monthly

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4

EAR - Formula

APR
EAR 1

Remember that the APR is the quoted rate

m is the number of times the interest is compounded

in a year

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4

Decisions, Decisions II

You are looking at two savings accounts. One pays 5.25%, with
daily compounding. The other pays 5.3% with semiannual
compounding. Which account should you use?
o

First account:
EAR = (1 + .0525/365)365 1 = 5.39%

Second account:
EAR = (1 + .053/2)2 1 = 5.37%

You should choose the first account (the account that

compounds daily), because you are earning a higher effective
interest rate.

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4

Computing APRs from EARs

If you have an effective rate, how can you compute the APR?
Rearrange the EAR equation and you get:

APR m (1 EAR)

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3

Computing Payments with APRs

Example
1
Suppose
you
want
to buy a new computer system and the store is

willing to allow you to make monthly payments. The entire

computer system costs $3,500. The loan period is for 2 years and
the interest rate is 16.9% with monthly compounding. What is your
monthly payment?

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3

Computing Payments with APRs

Example
1
continued
o
Formula Approach

Monthly rate = .169 / 12 = .01408333333

Number of months = 2(12) = 24
3500 = C[1 1 / 1.01408333333)24] / .
01408333333
C = 172.88
o

Calculator Approach

2(12) = 24 N; 16.9 / 12 = 1.408333333 I/Y; 3500 PV; CPT

PMT = -172.88

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Present Value with Daily Compounding

You need $15,000 in 3 years for a new car. If you can deposit money
into an account that pays an APR of 5.5% based on daily
compounding, how much would you need to deposit?

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3

Present Value with Daily Compounding

Continued
Formula Approach
o

Daily rate = .055 / 365 = .00015068493

Number of days = 3(365) = 1095
FV = 15,000 / (1.00015068493)1095 = 12,718.56
o

Calculator Approach

6-42

3(365) = 1095 N
5.5 / 365 = .015068493 I/Y
15,000 FV
CPT PV = -12,718.56

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Mortgages

In Canada, financial institutions are required by law to quote

mortgage rates with semi-annual compounding

Since most people pay their mortgage either monthly (12 payments
per year), semi-monthly (24 payments) or bi-weekly (26 payments),
you need to remember to convert the interest rate before calculating
the mortgage payment!

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Mortgages Example 1

Theodore D. Kat is applying to his friendly, neighborhood bank for a

mortgage of $200,000. The bank is quoting 6%. He would like to
have a 25-year amortization period and wants to make payments
monthly. What will Theodores payments be?

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Mortgage Example 1 continued

First, calculate the EAR

0.06
EAR 1
2

1 6.09%

Second, calculate the effective monthly rate

Effective Monthly Rate 1 0.0609

1
12

1 0.4939%

Then, calculate the monthly payment

C
1

300
0.004939
1.004939
C 1,279.61
200,000

OR, 300 N, 0.4939 I/Y, 200,000 PV, CPT PMT

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Continuous Compounding

Sometimes investments or loans are calculated based on continuous

compounding

EAR = eq 1
o

The e is a special function on the calculator normally denoted by e x

Example: What is the effective annual rate of 7% compounded

continuously?
o

6-46

EAR = e.07 1 = .0725 or 7.25%

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4

Quick Quiz Part V

What is the definition of an APR?

What is the effective annual rate?
Which rate should you use to compare alternative investments or
loans?

Which rate do you need to use in the time value of money

calculations?

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The Black Swan

(Nicholas Nassim Taleb)
The event is a surprise (to the observer).
The event has a major impact.
After the fact, it is rationalized by
hindsight, as if it could have been
expected.

http://tonymayadunne.com/2010/07/1
7/an-illuminating-blackout/