CHAPTER 6

DISCOUNTED CASH FLOW VALUATION

Copyright © 2016 by McGraw-Hill

Education. All rights reserved

Multiple Cash Flows – FV

Example 6.1
• You think you will be able to deposit $4,000 at
the end of each of the next three years in a
bank account paying 8 percent interest.
– You currently have $7,000 in the account.
– How much will you have in three years?
– How much will you have in four years?

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 Multiple Cash Flows – FV
Example 6.1
• Find the value at year 3 of each cash flow
and add them together
 Today (year 0): FV = 7000(1.08)3 = 8,817.98
 Year 1: FV = 4,000(1.08)2 = 4,665.60
 Year 2: FV = 4,000(1.08) = 4,320
 Year 3: value = 4,000
 Total value in 3 years = 8,817.98 + 4,665.60 + 4,320
+ 4,000 = 21,803.58

• Value at year 4 = 21,803.58(1.08) = 23,547.87

6F-3

Multiple Cash Flows – FV Example 2

• Suppose you invest $500 in a mutual

fund today and $600 in one year.
– If the fund pays 9% annually, how much will
you have in two years?

 FV = 500(1.09)2 + 600(1.09) = 1,248.05

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 Multiple Cash Flows –
Example 2 Continued
• How much will you have in 5 years
if you make no further deposits?

• First way:
 FV = 500(1.09)5 + 600(1.09)4 = 1,616.26

• Second way – use value at year 2:

 FV = 1,248.05(1.09)3 = 1,616.26

6F-5

Multiple Cash Flows – FV Example 3

• Suppose you plan to deposit $100 into an

account in one year and $300 into the
account in three years.
– How much will be in the account in five
years if the interest rate is 8%?

 FV = 100(1.08)4 + 300(1.08)2 = 136.05 +

349.92 = 485.97

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Multiple Cash Flows – PV Example 6.3
• You are offered an investment that will pay you $200 in
one year, $400 the next year, $600 the next year and
$800 at the end of the fourth year. You can earn 12
percent on very similar investments. What is the most
you should pay for this one?
• Find the PV of each cash flows and add them
 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 =
1,432.93
6F-7

Example 6.3 Timeline

0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93

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 Multiple Cash Flows
Using a Spreadsheet
• You can use the PV or FV functions in Excel to
find the present value or future value of a set
of cash flows

• Setting the data up is half the battle – if it is set

up properly, then you can just copy the
formulas

6F-9

Multiple Cash Flows – PV Another Example

• You are considering an investment that will pay you
$1,000 in one year, $2,000 in two years, and $3000 in
three years.
– If you want to earn 10% on your money, how much would
you be willing to pay?

 PV = 1000 / (1.1)1 = 909.09

 PV = 2000 / (1.1)2 = 1,652.89
 PV = 3000 / (1.1)3 = 2,253.94
 PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.92

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 Decisions, Decisions
• Your broker calls you and tells you that he
has this great investment opportunity.
– If you invest $100 today, you will receive $40 in one
year and $75 in two years.
– If you require a 15% return on investments of this
risk, should you take the investment?

 Use the CF keys to compute the value of the investment

• CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1
• NPV; I = 15; CPT NPV = 91.49
No, the broker is charging more than you would be willing to
pay.
6F-11

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%?

 Use cash flow keys:

• CF; CF0 = 0; C01 = 0; F01 = 39; C02 = 25,000; F02 = 5; NPV; I
= 12; CPT NPV = 1,084.71

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 Saving For Retirement Timeline

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

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

The cash flows in years 1 – 39 are 0 (C01 = 0; F01 =
39)
The cash flows in years 40 – 44 are 25,000 (C02 =
25,000; F02 = 5)
6F-13

Annuities and
Perpetuities Defined
• Annuity – finite series of equal payments that occur
at regular intervals
 If the first payment occurs at the end of the period, it is
called an ordinary annuity
 If the first payment occurs at the beginning of the period,
it is called an annuity due

• Perpetuity – infinite series of equal payments

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 Annuities and Perpetuities
Basic Formulas
• Perpetuity: PV = C / r
• Annuities:
 1 
1  (1  r ) t 
PV  C  
 r 

 

 (1  r ) t  1 
FV  C  
 r 

6F-15

Annuity – Example 6.5

• After carefully going over your budget, you have determined
you can afford to pay $632 per month toward a new sports car.
– You call up your local bank and find out that the going rate
is 1 percent per month for 48 months.
– How much can you borrow?

• To determine how much you can borrow, we need to calculate

the present value of $632 per month for 48 months at 1
percent per month.

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 Annuity – Example 6.5
• You borrow money TODAY so you need to compute
the present value.
 48 N; 1 I/Y; -632 PMT; CPT PV = 23,999.54 ($24,000)

• Formula:
 1 
 1  (1 .01) 48 
PV  632    23,999 .54
 .01 
 

6F-17

Annuity -
Sweepstakes Example
• Suppose you win the Publishers Clearinghouse $10
million sweepstakes.
– The money is paid in equal annual installments of
$333,333.33 over 30 years.
– If the appropriate discount rate is 5%, how much is the
sweepstakes actually worth today?

 PV = 333,333.33[1 – 1/1.0530] / .05 = 5,124,150.29

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 Buying a House
• You are ready to buy a house, and you have $20,000
for a down payment and closing costs.
– Closing costs are estimated to be 4% of the loan
value.
– You have an annual salary of $36,000, and the
bank is willing to allow your monthly mortgage
payment to be equal to 28% of your monthly
income.
– The interest rate on the loan is 6% per year with
monthly compounding (.5% per month) for a 30-
year fixed rate loan.
– How much money will the bank loan you?
– How much can you offer for the house?
6F-19

Buying a House - Continued

• Bank loan
 Monthly income = 36,000 / 12 = 3,000
 Maximum payment = .28(3,000) = 840
 PV = 840[1 – 1/1.005360] / .005 = 140,105

• Total Price
 Closing costs = .04(140,105) = 5,604
 Down payment = 20,000 – 5,604 = 14,396
 Total Price = 140,105 + 14,396 = 154,501

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 Finding the Payment
• Suppose you want to borrow $20,000 for a new car.
– You can borrow at 8% per year, compounded monthly
(8/12 = .66667% per month).
– If you take a 4 year loan, what is your monthly payment?

 20,000 = C[1 – 1 / 1.006666748] / .0066667

 C = 488.26

6F-21

Finding the Payment on a Spreadsheet

• Another TVM formula that can be found in a

spreadsheet is the payment formula
 PMT(rate,nper,pv,fv)
 The same sign convention holds as for the PV and
FV formulas

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 Finding the Number of Payments –
Example 6.6
• You ran a little short on your spring break
vacation, so you put $1,000 on your credit
card.
– You can afford only the minimum payment of $20
per month.
– The interest rate on the credit card is 1.5 percent
per month.
– How long will you need to pay off the $1,000?

6F-23

Finding the Number of Payments – Example

6.6
• Start with the equation, and remember your
logs.
 1,000 = 20(1 – 1/1.015t) / .015
 .75 = 1 – 1 / 1.015t
 1 / 1.015t = .25
 1 / .25 = 1.015t
 t = ln(1/.25) / ln(1.015) = 93.111 months = 7.76
years

• And this is only if you don’t charge anything

more on the card!
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Finding the Number of Payments – Another
Example
• Suppose you borrow $2,000 at 5%, and you are
going to make annual payments of $734.42.
– How long before you pay off the loan?

 2,000 = 734.42(1 – 1/1.05t) / .05

 .136161869 = 1 – 1/1.05t
 1/1.05t = .863838131
 1.157624287 = 1.05t
 t = ln(1.157624287) / ln(1.05) = 3 years

6F-25

Finding the Rate

• Suppose you borrow $10,000 from your
parents to buy a car.
– You agree to pay $207.58 per month for 60
months.
– What is the monthly interest rate?

 Sign convention matters!!!

 60 N
 10,000 PV
 -207.58 PMT
 CPT I/Y = .75%
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 Annuity – Finding the Rate Without a Financial
Calculator
• Trial and Error Process
 Choose an interest rate and compute the PV of the
payments based on this rate
 Compare the computed PV with the actual loan amount
 If the computed PV > loan amount, then the interest
rate is too low
 If the computed PV < loan amount, then the interest
rate is too high
 Adjust the rate and repeat the process until the
computed PV and the loan amount are equal

6F-27

Future Values for Annuities

• Suppose you begin saving for your retirement
by depositing $2,000 per year in an IRA.
– If the interest rate is 7.5%, how much will you
have in 40 years?

 FV = 2,000(1.07540 – 1)/.075 = 454,513.04

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 Annuity Due
• You are saving for a new house, and you put
$10,000 per year in an account paying 8%. The
first payment is made today.
– How much will you have at the end of 3 years?

 FV = 10,000[(1.083 – 1) / .08](1.08) = 35,061.12

6F-29

Annuity Due Timeline

0 1 2 3

10000 10000 10000

32,464

35,016.12

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 Perpetuity – Example 6.7
• Suppose the Fellini Co. wants to sell preferred
stock at $100 per share.
– A similar issue of preferred stock already
outstanding has a price of $40 per share and
offers a dividend of $1 every quarter.
– What dividend will Fellini have to offer if the
preferred stock is going to sell?

6F-31

Perpetuity – Example 6.7

• Perpetuity formula: PV = C / r

• Current required return:

 40 = 1 / r
 r = .025 or 2.5% per quarter

• Dividend for new preferred:

 100 = C / .025
 C = 2.50 per quarter
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 Work the Web Example
• Another online financial calculator can be found
at MoneyChimp.

• Go to MoneyChimp
http://www.moneychimp.com/calculator/
and work the following example:
 Choose annuity
 You just inherited $5 million. If you can earn 6% on
your money, how much can you withdraw each year
for the next 40 years?
 If assume annuity due, Payment = $313,497.81

6F-33

Table 6.2

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 Growing Annuity
A growing stream of cash flows with a fixed
maturity

C C  (1  g ) C  (1  g ) t  1
PV    
(1  r ) (1  r ) 2 (1  r ) t

C   (1  g )  
t

PV  1    
r  g   (1  r )  
 

6F-35

Growing Annuity: Example

A defined-benefit retirement plan offers to pay
$20,000 per year for 40 years and increase the
annual payment by three-percent each year.
What is the present value at retirement if the
discount rate is 10 percent?

$ 20 , 000   1 . 03  
40

PV  1      $ 265 ,121 . 57
. 10  . 03   1 . 10  

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 Growing Perpetuity
A growing stream of cash flows that lasts
forever

C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2 (1  r ) 3
C
PV 
rg

6F-37

Example: Growing Perpetuity

The expected dividend next year is $1.30, and
dividends are expected to grow at 5%
forever.
If the discount rate is 10%, what is the value of
this promised dividend stream?

$ 1 .3 0
PV   $ 2 6 .0 0
.1 0  .0 5
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 Effective Annual Rate (EAR)
• 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 and use that for comparison.

6F-39

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:
 Period rate = APR / number of periods per year

• You should NEVER divide the effective rate by the

number of periods per year – it will NOT give you the
period rate
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 Computing APRs
• What is the APR if the monthly rate is .5%?
 .5(12) = 6%

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

 .5(2) = 1%

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

monthly compounding?
 12 / 12 = 1%

6F-41

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.
 If you are looking at monthly periods, you need a
monthly rate.

• If you have an APR based on monthly compounding,

you have to use monthly periods, or adjust the interest
rate appropriately if you have payments other than
monthly

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 Computing EARs - Example
• Suppose you can earn 1% per month on $1 invested today.
 What is the APR? 1(12) = 12%
 How much are you effectively earning?
• FV = 1(1.01)12 = 1.1268
• Rate = (1.1268 – 1) / 1 = .1268 = 12.68%

• Suppose if you put it in another account, you earn 3% per

quarter.
 What is the APR? 3(4) = 12%
 How much are you effectively earning?
• FV = 1(1.03)4 = 1.1255
• Rate = (1.1255 – 1) / 1 = .1255 = 12.55%

6F-43

EAR - Formula

m
 AP R 
EAR  1   1
 m 
Remember that the APR is the quoted rate, and
mRemember
is the number
that of
thecompounding periods
APR is the quoted perand
rate, year
m is the number of compounding periods per year

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 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?

 First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
 Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%

• Which account should you choose and why?

6F-45

Decisions, Decisions II, Continued

• Let’s verify the choice. Suppose you invest $100 in each
account. How much will you have in each account in one
year?

 First Account:
• Daily rate = .0525 / 365 = .00014383562
• FV = 100(1.00014383562)365 = 105.39
 Second Account:
• Semiannual rate = .0539 / 2 = .0265
• FV = 100(1.0265)2 = 105.37

• You have more money in the first account.

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 Computing
APRs from EARs
• If you have an effective rate, how can you
compute the APR? Rearrange the EAR
equation and you get:

A P R  m  (1  EA R ) - 1
1
m
 

6F-47

Example: APR
• Suppose you want to earn an effective rate of 12%
and you are looking at an account that compounds
on a monthly basis. What APR must they pay?

 
A P R  1 2 (1  . 1 2 ) 1 / 1 2  1  . 1 1 3 8 6 5 5 1 5 2
o r 1 1 .3 9 %
6F-48

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 Computing Payments
with APRs
• 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?

 Monthly rate = .169 / 12 = .01408333333

 Number of months = 2(12) = 24
 3,500 = C[1 – (1 / 1.01408333333)24] / .01408333333
 C = 172.88

6F-49

Future Values with

Monthly Compounding
• Suppose you deposit $50 a month into an
account that has an APR of 9%, based on
monthly compounding.
– How much will you have in the account in 35 years?

 Monthly rate = .09 / 12 = .0075

 Number of months = 35(12) = 420
 FV = 50[1.0075420 – 1] / .0075 = 147,089.22

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 Present Value with
Daily Compounding
• You need $15,000 in 3 years for a new car.
– If you can deposit 1 lump sum into an account that
pays an APR of 5.5% based on daily compounding,
how much would you need to deposit?

 Daily rate = .055 / 365 = .00015068493

 Number of days = 3(365) = 1,095
 FV = 15,000 / (1.00015068493)1095 = 12,718.56

6F-51

Continuous Compounding
• Sometimes investments or loans are figured
based on continuous compounding
• EAR = eq – 1
 The e is a special function on the calculator
normally denoted by ex

• Example: What is the effective annual rate of

7% compounded continuously?
 EAR = e.07 – 1 = .0725 or 7.25%

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