Chapter 6

Discounted Cash Flow

Valuation

6-0
 Key Concepts and Skills
Be able to compute:
• the future value of multiple cash flows
• the present value of multiple cash flows
• the future and present value of annuities

Be able to understand:
• the difference between the APR and the
EAR
• the difference between “ordinary annuity”
and “annuity due”
6-1
 Multiple Cash Flows –Future
Value Example 6.1

• You think that you will be able to

deposits £4000 at the end of each
of the next three years in a bank
account paying 8 percent interest.
You currently have £7000 in the
account? How much will you have
in three years? In four years?

6-2
 Timeline 6.1

0 1 2 3

7,000 4,000 4,000 4,000

6-3
 Answer 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
2
• Year 1: FV = 4,000(1.08) = 4,665.60
• Year 2: FV = 4,000(1.08) = 4,320
• Year 3: value = 4,000
• Total value in 3 years = 8817.98 +
4665.60 + 4320 + 4000 = 21,803.586-4
 Timeline 6.1
0 1 2 3

7,000 4,000 4,000 4,000

4,320
4665.60
8817.98

21,803.58

6-5
 Multiple Cash Flows – FV
Example 6.2
• Suppose you invest $500 in a
mutual (shared, joint) 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)
= 1248.05 6-6
 Multiple Cash Flows – Answer
6.2 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 =
1616.26
• Second way – use value at year 2:
•FV = 1248.05(1.09)3 = 1616.26
6-7
 Multiple Cash Flows – FV
Example 6.3 a
• a) Suppose you plan to deposit $100
into an account in one year and $300
into the account in the third year. How
much will be in the account in five
years if the interest rate is 8%?

4 2
• FV = 100(1.08) + 300(1.08)
= 136.05 + 349.92 = 485.97
6-8
 Example 6.3 b
• b) Suppose you plan to deposit $100
into an account in one year and $300
into the account in the fifth year. How
much will be in the account in five
years if the interest rate is 8%?

4
• FV = 100(1.08) + 300
= 136.05 + 300 = 436.05
6-9
 Answer 6.3 c
• c) Suppose you plan to deposit $100
into an account in one year and $300
in the next four year. How much will
be in the account in five years if the
interest rate is 8%?

FV = 100(1.08)4 + 300(1.08)3 +
300(1.08)2 + 300(1.08)1 + 300
=
6-10
 Multiple Cash Flows – Present
Value Example 6.4
• 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 fourth year.
You can earn 12 % on very similar
investments.

6-11
 Timeline 6.4
0 1 2 3 4

200 400 600 800

6-12
 Answer 6.4
• Find the PV of each cash flows and
add them
1
• Year 1 CF: 200 / (1.12) = 178.57
• Year 2 CF: 400 / (1.12)2 = 318.88
• Year 3 CF: 600 / (1.12)3 = 427.07
4
• Year 4 CF: 800 / (1.12) = 508.41
Total PV = 178.57 + 318.88 + 427.07
+ 508.41 =1432.93
6-13
 Timeline 6.4
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1432.93

6-14
 Multiple Cash Flows – PV
Another Example 6.5

• You are considering an investment that

will pay you $1000 in one year, $2000
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?

6-15
 Timeline 6.5

0 1 2 3

1,000 2,000 3,000

6-16
 Answer 6.5

• PV = 1000 / (1.1)1 = 909.09

2
• PV = 2000 / (1.1) = 1652.89
• PV = 3000 / (1.1)3 = 2253.94
PV = 909.09 + 1652.89 + 2253.94 =
4815.92

6-17
 Timeline 6.5

0 1 2 3

1,000 2,000 3,000

909.09
1,652.89

2,253.94
4,815.92

6-18
 Annuities

• Annuity: a sequence of equal cash

flows, occurring at the end of each
period.

0 1 2 3 4
 Examples of Annuities:

• If you buy a bond, you will

receive equal coupon interest
payments over the life of the
bond.
• If you borrow money to buy a
house or a car, you will pay a
stream of equal payments.
 Annuities – Basic Formula
• Annuity – equal payments that occur at regular
intervals

6-21
• Notice that the calculator solution is slightly
different because of rounding errors in the
tables.

6-22
 Annuities and Perpetuities –
Basic Formula
• Perpetuity – infinite series of equal
payments
• Special case of an annuity arises
when the level of stream of CF
(month, year etc.) continues
forever.
PV = A
r
6-23
 Example 6.6: Future Value - annuity
If you invest $1,000 at the end of the next 3
years, at 8%, how much would you have
after 3 years?

1000 1000 1000

0 1 2 3

FV = 1,000 (1.08)3 - 1
0.08
= $3246.40
 Example 6.7: Present Value - annuity
What is the PV of $1,000 at the end of each of
the next 3 years, if the opportunity cost is
8%?

1000 1000 1000

0 1 2 3

1
PV = 1000 1 - (1.08 )3 = $2,577.10
0.08
Solution:
 Example 6.8

What should you be willing to pay

in order to receive $10,000
annually forever, if you require 8%
per year on the investment?

A $10,000
PV = =
r 0.08
= $125,000
 Example 6.9: Annuity

• You have determined that you can

afford to pay $632 per month
toward a new Italian sports car.
You call up your bank and find out
that the going rate is 1% per month
for 50 months. How much can you
borrow?

6-27
 Answer 6.9

•Formula:

6-28
 Example 6.10: Future Values for
Annuities
• Suppose you begin saving for
your retirement by depositing
$2000 per year in an IRA. If the
interest rate is 7.5%, how much
will you have in 40 years?

6-29
 Earlier, we examined this
“ordinary” annuity:

1000 1000 1000

0 1 2 3
Using an interest rate of 8%, we
find that:
• The Future Value (at 3) is
$3,246.40.
• The Present Value (at 0) is
$2,577.10.
 What about this annuity?

1000 1000 1000

0 1 2 3
• Same 3-year time line,
• Same 3 $1000 cash flows, but
• The cash flows occur at the
beginning of each year, rather
than at the end of each year.
• This is an “annuity due.”
 Future Value - annuity due
If you invest $1,000 at the beginning of each
of the next 3 years at 8%, how much would
you have at the end of year 3?
1000 1000 1000

0 1 2 3

Mathematical Solution:
Simply compound the FV of the ordinary annuity one
more period:
Mathematical Solution: Simply compound the
FV of the ordinary annuity one more period:

FV = A (FVIFA i, n ) (1 + i)
FV = 1,000 (FVIFA .08, 3 ) (1.08)
FV = A (1 + r)n - 1
(1 + r)
r
FV = 1,000 (1.08)3 - 1
(1.08) = 3,506.11
.08
Present Value - annuity due
What is the PV of $1,000 at the beginning of
each of the next 3 years, if your opportunity
cost is 8%?

1000 1000 1000

0 1 2 3

Mathematical Solution: Simply compound the

FV of the ordinary annuity one more period:
Mathematical Solution: Simply
compound the ordinary annuity one more
period:
PV = A (PVIFA r, n ) (1 + r)
PV = 1,000 (PVIFA 0.08, 3 ) (1.08)

6-35
 Uneven Cash Flows

-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

• Is this an annuity?
• How do we find the PV of a cash
flow stream when all of the cash
flows are different? (Use a 10%
discount rate).
 Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

• Sorry! There’s no quickie for this

one. We have to discount each
cash flow back separately.
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

period CF PV (CF)
0 -10,000 -10,000.00
1 2,000 1,818.18
2 4,000 3,305.79
3 6,000 4,507.89
4 7,000 4,781.09
PV of Cash Flow Stream: $ 4,412.95
 Example 6.11

• Cash flows from an investment are

expected to be $40,000 per year at
the end of years 4, 5, 6, 7, and 8. If
you require a 20% rate of return,
what is the PV of these cash
flows?
 Timeline 6.11

0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8
• This type of cash flow sequence
is often called a “deferred
annuity.”
 0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8

How to solve:

1) Discount each cash flow back

to time 0 separately. OR/
0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8

119,624

2) Find the PV of the annuity:

PV3= $119,624
Then discount this single sum
back to time 0.
 0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8

119,624

FV = PV (1+r)t
3
FV = 119,624 = PV(1+0.20)
Solve: PV = $69,226.85
 0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8

69,226 119,624

• The PV of the cash flow

stream is $69,226.
 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.

6-45
 Compounding Intervals
• Suppose that rate is quoted as 10%
Compounded Annually, t=5 years; Then
FV=?
FV=PV (1+0.10)5
• Compounded Semi-Annually
r=0.10/2 = 0.05, t=5*2=10
FV=PV (1+0.05)10
Then this means that investment actually
pays 5% every 6 months.
6-46
 Compounding Intervals
• Compound Quarterly
r=0.10/4=0.025, t=5*4=20
20
FV=PV (1+0.025)
• Compound Monthly
r=0.10/12=0.0083, t=5*12=60
FV=PV (1+0.0083)60
• Compound Daily
r=0.10/365=0.00027, t=5*365=1825
6-47
Assume that you invested $1000 in
a bank, t=1?
• A)3% per year compounded monthly?
FV=1000 [1+(0.03/12)] 1=1002.5
• B)3.5% per year compounded
quarterly?(i.e.compounded in every 3
month)
FV=1000 [1+(0.035/4)] 1=1008.75
• C)4% Compounded annually?
FV=1000 [1+0.04]1 = 1040
Assume that you invested $1000 in
a bank?
• A)3% per year compounded monthly?
FV=1000+[1000*(3/100)*(31/365)]=1002.54

• B)3.5% per year compounded

quarterly?(i.e.compounded in every 3 month)
FV=1000+[1000*(3.5/100)*(91/365)]=1008.726

• C)4% Compounded annually?

FV=1000+[1000*(4/100)*(365/365)]=1040
The Value of $100 Compounded at
Various Nonannual Periods
For 10 Year at i% 2% 5%
Compounded Annually 121.90 162.89
Compounded Semiannually 122.02 163.86
Compounded Quarterly 122.08 164.36
Compounded Monthly 122.12 164.70
Compounded Weakly (52) 122.14 164.83
Compounded Daily (365) 122.14 164.87

6-50
 Example 6.12

• After graduation, you plan to

invest $400 per month in the stock
market. If you earn 12% per year
on your stocks, how much will you
have accumulated when you retire
in 30 years?
 Retirement Example 6.12

400 400 400 400

0 1 2 3 . . . 360
 Retirement Example 6.12

Mathematical Solution:
FV = A (FVIFA i, n )
FV = 400 (FVIFA .01, 360 ) (can’t use FVIFA table)

FV = A (1 + r)t- 1
i
FV = 400 (1.01)360-1 = $1,397,985.65
0.01
Example 6.13: House Payment
If you borrow $100,000 at 7%
fixed interest for 30 years in
order to buy a house, what
will be your monthly house
payment?
 House Payment Example 6.13
Mathematical Solution:

PV = A (PVIFA i, n )
100,000 = A (PVIFA .005833. 360 ) (can’t use PVIFA table)

1
PV = A 1 - (1 + r)t
i

1
100,000 = A 1 - (1.005833 )360
A=$665.30 0.005833
Example 6.14: Finding the Payment

• Suppose you want to borrow

$20,000 for a new car. You can
borrow at 8% per year
compounded monthly. If you take
a 4 year loan, what is your
monthly payment?

6-56
 Answer 6.14

8/12 = .66667% per month

A = 488.26

6-57
 Comparing Rates: The Effect of
Compounding Periods
• Suppose that rate is quoted as 10%
compounded semi-annually, than what this
means: investment pays 5% every six
months.
• Question that arise is: are these two same?
• $1 * (1.10)1 = $1.10 …..10% is quoted i.r.
• $1 * (1.05)2 = $1.1025 ….10.25% is EAR
• This is 0.025 more.

6-58
 APRs and EARs

• Interest rates are quoted in

different way, is the way that
mislead borrowers and investors.

• Annual Percentage Rate (APR)

• Effective Annual Rate (EAR)

6-59
 APR
• APR is the nominal interest rate that is
not adjusted for the full effect of
compounding. (Also known as nominal
annual rate)
• Nominal interest rate ignores the time
value of money.

• APR =
Period Rate * the number of periods per year

6-60
 Annual Percentage Rate
• This is the annual rate that is quoted by law
• If the i.r is quoted in terms of an APR, then this
indicates the amount of simple interest earned
in 1 year, i.e. the amount of interest earned
without the effect of compounding.
• As the APR does not include the effect of
compounding, the APR quote is typically less
than the actual amount of interest that you will
earn.
• To compute the acual amount that you will earn
in 1 year, the APR must first be converted to an
Effective Annual Rate (EAR).
6-61
 Effective Annual Rate (EAR)
• This is the actual rate paid or received after
accounting for compounding that occurs
during the year
• When time value of money is taken into
consideration, the interest rate is called
effective interest rate.
• If you want to compare different investments
(or interest rates) with different
compounding periods you need to compute
the EAR and use that for comparison.
6-62
 EAR - Formula

Remember that the APR is the quoted rate

m is the number of compounding periods
per year

6-63
Continious Compounding Interest
As the number of times the interest is
compounded gets extremely large,
the EAR approaches:

q stand for the quated rate

e is the number 2,71828

6-64
 Computing APRs from EARs
• If you have an effective rate, how can
you compute the APR? Rearrange
the EAR equation and you get:

6-65
 Example 6.15 a: EAR
a) 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?

6-66
 Answer 6.15 a
• First account:
•EAR = (1 + 0.0525/365)365 – 1=
5.39%
• Second account:
•EAR = (1 + 0.053/2)2 – 1 = 5.37%

• Which account should you choose?

6-67
 6.15 b

• b) Which of this is the best if you are

thinking of openning a savings account ?
Which of these is best if they represent
loan rates?
• Bank A: 15 % compounded daily
Bank B: 15.5 % compounded quarterly
Bank C: 16 % compounded annually

6-68
 Answer 6.15 b

EARBank A = (1 + .015/365)365 – 1
= 16.18%

4
EARBank B = (1 + .155/4) – 1
= 16.42%
(0.155/4 =0,03875 = 3,875% per quarter)
At this rate, an investment of $1 for 4 quarters
would grow to = [$1 * (1,03875)] 4 = 1,1642
EARBank C= (1 + .16)1 – 1
= 16% 6-69
 Example 6.16
• Suppose that a credit card agreement
quotes an interest rates of 18% APR.
Monthly payments are required. What is
the actual interest rate you pay on such a
credit card?
• EAR = (1+0.18/12)12 -1
= 1.1956 – 1
= 19.56% This is the rate you actually
pay
6-70
 Example 6.17
• You have just received your first credit card
and the problem is the rate. It look pretty
high to you. The annual percentage rate
(APR) is listed at 21.7 percent, and when
you look closer, you notice that the interest
rate is compounded daily. What is the
annual percentage yield, or effective
annual rate, on your credit card?

6-71
Thus, in reality,the effective annual rate , is
actually 24.2264 percent

6-72
 Example 6.18: 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?

6-73
Answer 6.18

6-74
 Example 6.19: Computing
Payments with APRs
• Suppose you want to buy a new computer
system and the store is willing to sell it to
allow you to make monthly payments. The
entire computer system costs $3500. The
loan period is for 2 years and the interest
rate is 16.9% compounded monthly. What is
your monthly payment?

6-75
 Answer 6.19

• Monthly rate = 0.169/12

= 0.0140833
• Number of months = 2(12) = 24

• A = 172.88
6-76
Example 6.20: Future Values with
Monthly Compounding

• Suppose you deposit $50 a month

into an account that has an APR of
9% compounded monthly. How
much will you have in the account
in 35 years?

6-77
 Answer 6.20
• Monthly rate =0.09 / 12 =0.0075
• Number of months = 35(12)
= 420

6-78
 Example 6.21: 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%, compounded daily. How
much would you need to deposit?

6-79
 Answer 6.21
• Daily rate = 0.055 / 365
= 0.00015

• Number of days = 3(365) = 1095

•PV = 15,000
1095
(1.00015)
= 12,718.56
6-80
Table

6-81
 Suggested Problems
• 1-19, 21, 24-28, 30, 32-38, 40, 42-44, 46,
68.