Chapter 5

Discounted Cash Flow

Valuation

1
Multiple Cash Flows – FV
Example 5.1
• Find the value at year 3 of each cash
flow and add them together.
• Today (year 0): FV = $7,000(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

2
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

3
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

4
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

5
Multiple Cash Flows –
PV Example 5.3
• Find the PV of each cash flow 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

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 Example 5.3 Time Line
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93

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Example: Spreadsheet
Strategies
• 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
• Click on the Excel icon for an
example

8
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?

 PV = $40/(1.15)1 + $75/(1.15)2 =
$91.49
 No! The broker is charging more
than you would be willing to pay.

9
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%?
 PV = $25,000/(1.12)40 + $25,000/
(1.12)41 + $25,000/(1.12)42 +
$25,000/(1.12)43 +
$25,000/(1.12)44 = $1,084.71

10
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 

12
Annuity – Example 5.5

• You borrow money TODAY so you

need to compute the present
value.
• Formula:

 1 
1 
 (1.01) 48 
PV  632   23,999.54
 .01 
 

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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

14
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?

15
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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Example: Spreadsheet Strategies
– Annuity PV
• The present value and future value
formulas in a spreadsheet include
a place for annuity payments
• Click on the Excel icon to see an
example

17
Quick Quiz

• You know the payment amount for

a loan and you want to know how
much was borrowed. Do you
compute a present value or a
future value?
• You want to receive $5,000 per
month in retirement. If you can
earn .75% per month and you
expect to need the income for 25
years, how much do you need to
have in your account at
retirement?

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Quick Quiz
• You want to receive $5,000 per month for
the next 5 years. How much would you
need to deposit today if you can earn .
75% per month?
• What monthly rate would you need to earn
if you only have $200,000 to deposit?
• Suppose you have $200,000 to deposit
and can earn .75% per month.
• How many months could you receive
the $5,000 payment?
• How much could you receive every
month for 5 years?

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Perpetuity – Example 5.7

• 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

20
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.

21
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

22
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%
 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.

23
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) * 100 = .1268 =
12.68%
• Suppose if you put it in another account, and
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) * 100 = .1255 =
12.55%

24
EAR - Formula

m
 APR 
EAR  1    1
 m 
Remember that the APR is the quoted rate,
and m is the number of compounds per year

25
Pure Discount Loans –
Example 5.11
• Treasury bills are excellent
examples of pure discount loans.
The principal amount is repaid at
some future date, without any
periodic interest payments.
• If a T-bill promises to repay
$10,000 in one year and the
market interest rate is 7 percent,
how much will the bill sell for in
the market?
 PV = $10,000 / 1.07 = $9,345.79

26
Interest-Only Loan - Example

• Consider a 5-year, interest-only loan with

a 7% interest rate. The principal amount
is $10,000. Interest is paid annually.
• What would the stream of cash flows
be?
• Years 1 – 4: Interest payments of .
07($10,000) = $700
• Year 5: Interest + principal =
$10,700
• This cash flow stream is similar to the
cash flows on corporate bonds. We will
talk about them in greater detail later.

27
Amortized Loan with Fixed
Payment - Example
• Each payment covers the interest
expense; plus, it reduces principal
• Consider a 4-year loan with annual
payments. The interest rate is 8%
and the principal amount is
$5,000.
• What is the annual payment?
• $5,000 = C[1 – 1 / 1.084] / .08
• C = $1,509.60

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Amortization Table for Example
Year Beg. Total Interest Principal End.
Balance Payment Paid Paid Balance

1 5,000.00 1,509.60 400.00 1,109.60 3,890.40

2 3,890.40 1,509.60 311.23 1,198.37 2,692.03

3 2,692.03 1,509.60 215.36 1,294.24 1,397.79

4 1,397.79 1,509.60 111.82 1,397.78 .01

Total 6,038.40 1,038.41 4,999.99

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Example: Spreadsheet
Strategies
• Each payment covers the interest
expense; plus, it reduces principal
• Consider a 4-year loan with annual
payments. The interest rate is 8% and
the principal amount is $5,000.
• What is the annual payment?
•4N
• 8 I/Y
• 5,000 PV
• CPT PMT = -1,509.60
• Click on the Excel icon to see the
amortization table

30
Quick Quiz

• What is a pure discount loan?

What is a good example of a pure
discount loan?
• What is an interest-only loan?
What is a good example of an
interest-only loan?
• What is an amortized loan? What
is a good example of an amortized
loan?

• No Homework!!!!! Woo-hooooooo!

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