Chapter 4

Discounted Cash Flow Valuation

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Be able to compute the future value and/or
present value of a single cash flow or series of
cash flows
 Be able to compute the return on an
investment
 Be able to use a financial calculator and/or
spreadsheet to solve time value problems
 Understand perpetuities and annuities
4-1
Chapter Outline
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 Loan Amortization
4.6 What Is a Firm Worth?

4-2
4.1 The One-Period Case
 If you were to invest $10,000 at 5-percent interest
for one year, your investment would grow to
$10,500.

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:
$10,500 = $10,000×(1.05)
❑ The total amount due at the end of the investment is
called the Future Value (FV).
4-3
4.1 The One-Period Case
 If you were to invest $10,000 at 10-percent interest
for one year,

$.... would be interest

$.... is the principal repayment
$.... is the total due.)
❑ How much is the Future Value (FV) of this
investment?

4-4
4.1 The One-Period Case
 If you were to invest $10,000 at 10-percent interest
for one year,

$ 1,000 would be interest

$ 10,000 is the principal repayment
$ 11,000 is the total due.)
❑ How much is the Future Value (FV) of this
investment? 11,000

4-5
Future Value
 In the one-period case, the formula for FV can
be written as:
FV = C0×(1 + r)

Where C0 is cash flow today (time zero), and

r is the appropriate interest rate.

4-6
Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s dollars.
$ 10 , 000
$ 9 ,523 . 81 =
1 . 05
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is called the Present Value (PV).

Note that $10,000 = $9,523.81×(1.05).

4-7
Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 10-percent, how much would
your investment be worth in today’s dollars?

4-8
 Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 10-percent, how much would
your investment be worth in today’s dollars?
$ 10 ,000
$ 9 ,090 .91 =
1 .1

the Present Value (PV) of the promised $10,000 is $9,090.91

4-9
Present Value
 In the one-period case, the formula for PV can
be written as:
C1
PV =
1+ r

Where C1 is cash flow at date 1, and

r is the appropriate interest rate.

4-10
Net Present Value
 The Net Present Value (NPV) of an
investment is the present value of the
expected cash flows, less the cost of the
investment.
 Suppose an investment that promises to pay
$10,000 in one year is offered for sale for
$9,500. Your interest rate is 5%. Should you
buy?

4-11
Net Present Value
$10,000
NPV = −$9,500 +
1.05
NPV = −$9,500 + $9,523.81
NPV = $23.81
The present value of the cash inflow is greater
than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.
4-12
Net Present Value
In the one-period case, the formula for NPV can be
written as:
NPV = –Cost + PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :

$9,500×(1.05) = $9,975 < $10,000

4-13
4.2 The Multiperiod Case
 The general formula for the future value of an
investment over many periods can be written
as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.
4-14
Future Value
 Suppose a stock currently pays a dividend of
$1.10, which is expected to grow at 40% per
year for the next five years.
 What will the dividend be in five years?

FV = C0×(1 + r)T

$5.92 = $1.10×(1.40)5

4-15
Future Value and Compounding
 Notice that the dividend in year five, $5.92,
is considerably higher than the sum of the
original dividend plus five increases of 40-
percent on the original $1.10 dividend:

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

4-16
Future Value and Compounding
$ 1 . 1 0  (1 . 4 0 ) 5

$ 1 . 1 0  (1 . 4 0 ) 4
$ 1 . 1 0  (1 . 4 0 ) 3
$ 1 . 1 0  (1 . 4 0 ) 2
$ 1 . 1 0  (1 . 4 0 )

$ 1 .1 0 $ 1 .5 4 $ 2 .1 6 $ 3 .0 2 $ 4 .2 3 $ 5 .9 2

0 1 2 3 4 5 4-17
Present Value and Discounting
 How much would an investor have to set
aside today in order to have $20,000 five
years from now if the current rate is 15%?
PV $20,000

0 1 2 3 4 5
$ 20 , 000
$ 9 ,943 . 53 =
(1 . 15 ) 5
4-18
4.5 Finding the Number of Periods
If we deposit $5,000 today in an account paying 10%,
how long does it take to grow to $10,000?
F V = C 0  (1 + r ) T
$ 1 0 , 0 0 0 = $ 5 , 0 0 0  (1 . 1 0 ) T

$ 10 , 000
(1 . 10 ) = T
=2
$ 5 , 000
ln( 1 . 1 0 ) T = ln( 2 )

ln( 2 ) 0 . 6931
T = = = 7 . 27 years
ln( 1 . 10 ) 0 . 0953
4-19
What Rate Is Enough?
Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of
your child’s education? About 21.15%.
F V = C 0  (1 + r ) T
$ 5 0 , 0 0 0 = $ 5 , 0 0 0  (1 + r ) 12

$ 50 , 000
(1 + r ) =
12
= 10 (1 + r ) = 1 0 1 1 2
$ 5 , 000

r = 10 1 12
− 1 = 1 .2 1 1 5 − 1 = .2 1 1 5
4-20
Calculator Keys
 Texas Instruments BA-II Plus
◼ FV = future value
◼ PV = present value
◼ I/Y = periodic interest rate
 P/Y must equal 1 for the I/Y to be the periodic rate
 Interest is entered as a percent, not a decimal

◼ N = number of periods
◼ Remember to clear the registers (CLR TVM) after
each problem
◼ Other calculators are similar in format

4-21
Multiple Cash Flows
 Consider an investment that pays $200 one
year from now, with cash flows increasing by
$200 per year through year 4. If the interest
rate is 12%, what is the present value of this
stream of cash flows?
 If the issuer offers this investment for $1,500,
should you purchase it?

4-22
Multiple Cash Flows
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
Present Value < Cost → Do Not Purchase
4-23
Valuing “Lumpy” Cash Flows
First, set your calculator to 1 payment per year.
Then, use the cash flow menu:
CF0 0 CF3 600 I 12

CF1 200 F3 1 NPV 1,432.93

F1 1 CF4 800

CF2 400 F4 1

F2 1 4-24
4.3 Compounding Periods
Compounding an investment m times a year for
T years provides for future value of wealth:
m T
 r 
FV = C 0   1 + 
 m

4-25
Compounding Periods
❑ For example, if you invest $50 for 1 years at
12% compounded semi-annually, your
investment will grow to

2
 .12 
FV = $ 50   1 +  = $ 50  (1 . 06 ) 2
= $ 56 .18
 2 

4-26
Compounding Periods
❑ For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to

2 3
 . 12 
FV = $ 50   1 +  = $ 50  (1 . 06 ) 6 = $ 70 . 93
 2 

4-27
Effective Annual Rates of Interest
A reasonable question to ask in the above
example is “what is the effective annual rate of
interest on that investment?”
. 12 2  3
F V = $ 50  (1 + ) = $ 50  (1 . 06 ) = $ 70 . 93
6

2
The Effective Annual Rate (EAR) of interest is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
$ 5 0  (1 + E A R ) 3 = $ 7 0 . 9 3
4-28
Effective Annual Rates of Interest
F V = $ 5 0  (1 + E A R ) 3 = $ 7 0 . 9 3
$ 70 .93
(1 + EAR ) = 3

$ 50
13
 $ 70 . 93 
EAR =   − 1 = .1236
 $ 50 
So, investing at 12.36% compounded annually
is the same as investing at 12% compounded
semi-annually.
4-29
Effective Annual Rates of Interest
 Find the Effective Annual Rate (EAR) of an
18% APR loan that is compounded monthly.
 What we have is a loan with a monthly
interest rate rate of 1½%.
 This is equivalent to a loan with an annual
interest rate of 19.56%.
m 12
 r   . 18 
 1 +  =  1 +  = (1 . 015 ) 12
= 1 . 1956
 m  12 
4-30
EAR on a Financial Calculator

Texas Instruments BAII Plus

keys: description:
[2nd] [ICONV] Opens interest rate conversion menu
[↑] [C/Y=] 12 [ENTER] Sets 12 payments per year
[↓][NOM=] 18 [ENTER] Sets 18 APR.
[↓] [EFF=] [CPT] 19.56

4-31
Continuous Compounding
 The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately equal
to 2.718. ex is a key on your calculator. 4-32
4.4 Simplifications
 Perpetuity
◼ A constant stream of cash flows that lasts forever
 Growing perpetuity
◼ A stream of cash flows that grows at a constant rate
forever
 Annuity
◼ A stream of constant cash flows that lasts for a fixed
number of periods
 Growing annuity
◼ A stream of cash flows that grows at a constant rate for
a fixed number of periods 4-33
Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r
4-34
Perpetuity: Example
What is the value of a British consol that
promises to pay £15 every year for ever?
The interest rate is 10-percent.
£15 £15 £15
…
0 1 2 3

£15
PV = = £150
. 10
4-35
Growing Perpetuity
A growing stream of cash flows that lasts forever
C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C  (1 + g ) C  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r−g 4-36
Growing Perpetuity: Example
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?
$1.30 $1.30×(1.05) $1.30 ×(1.05)2
…
0 1 2 3

$ 1 . 30
PV = = $ 26 . 00
. 10 − . 05
4-37
Annuity
A constant stream of cash flows with a fixed maturity
C C C C

0 1 2 3 T

C C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) T

C  1 
PV = 1 − (1 + r ) T 
r   4-38
Annuity: Example
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on 36-
month loans?

$400 $400 $400 $400

0 1 2 3 36

$ 400  1 
PV = 1− 36 
= $ 12 ,954 . 59
. 07 / 12  (1 + . 07 12 )  4-39
 What is the present value of a four-year annuity of $100 per
year that makes its first payment two years from today if the
discount rate is 9%?

4
$ 100 $ 100 $ 100 $ 100 $ 100
P V1 = 
t =1 (1 . 09 ) t
= 1
+
(1 . 09 ) (1 . 09 ) 2
+ 3
+
(1 . 09 ) (1 . 09 ) 4
= $ 323 . 97

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5

4-40
2-40
Growing Annuity
A growing stream of cash flows with a fixed maturity
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
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 )  
  4-41
Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000 per
year for 40 years and increase the annual payment by 3% each
year. What is the present value at retirement if the discount rate
is 10%?

$20,000 $20,000×(1.03) $20,000×(1.03)39

0 1 2 40

$ 20 ,000   1 .03  
40

PV = 1 −    = $ 265,121 .57
.10 − .03   1 .10   4-42
Growing Annuity: Example
You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?
$ 8 , 5 0 0  (1 . 0 7 ) 2 = $ 8 , 5 0 0  (1 . 0 7 ) 4 =
$ 8 , 5 0 0  (1 . 0 7 ) = $ 8 , 5 0 0  (1 . 0 7 ) 3 =
$ 8 , 5 0 0 $9,095 $ 9 , 7 3 1 . 6 5 $ 1 0 , 4 1 2 . 8 7 $ 1 1 ,1 4 1 . 7 7

0 1 2 3 4 5
$34,706.26
4-43
DEFERRED ANNUITY
Deferred annuity is one where the cash flows
do not begin until some time in the future.

Example 22:

What is the present value of an ordinary annuity of

$1000 per year for 3 years at 8% interest, where the
first payment starts in 2 years’ time?
Example 16: PV of Ordinary Annuity
An amount of $1000 is given to Greedy at the end of
each year for the next 3 years. Assuming interest is
compounded at 8%. If Greedy wants the money today,
what is the present value of the annuity?
Example 16: PV of Ordinary Annuity
An amount of $1000 is given to Greedy at the end of
each year for the next 3 years. Assuming interest is
compounded at 8%. If Greedy wants the money today,
what is the present value of the annuity?

1000 x [1- (1+ 8%)-3]/8% =

Present Value of Ordinary Annuity
Present Value of Ordinary Annuity
Present Value of Ordinary Annuity
Example 17: PV of Annuity Due

An amount of $800 is given to Greedy at the beginning

of each year for 5 years. Assuming interest is
compounded at 8%. If Greedy wants the money today,
what is the present value of the annuity?
Example 17: PV of Annuity Due

An amount of $800 is given to Greedy at the beginning

of each year for 5 years. Assuming interest is
compounded at 8%. If Greedy wants the money today,
what is the present value of the annuity?

800 + 800 x [1-(1+8%)-4]/8%

Present Value of Annuity Due
Present Value of Annuity Due
Future Value of Ordinary Annuity

0 1 2 3
PMT PMT PMT
FV3= PMT x (1+i)2 + PMT x (1+i)1 + PMT x (1+i)0
= PMT x [(1+i)3-1]/i
Future Value of Annuity Due

0 1 2 3
PMT PMT PMT
FV3= PMT x (1+i)3 + PMT x (1+i)2 + PMT x
(1+i)1
= [PMT x (1+i)2 + PMT x (1+i)1 + PMT x
(1+i)0] x (1+i)
= PMT x [(1+i)3-1]/i x (1+i)
Example 14: FV of Ordinary Annuity

$1000 is invested at the end of each year for the

next three years at 8% p.a. How much is the
future value at the end of the third year?
Example 14: FV of Ordinary Annuity

$1000 is invested at the end of each year for the

next three years at 8% p.a. How much is the
future value at the end of the third year?

FV3= 1000x[(1+8%)3-1]/0.08
Example 15: FV of Annuity Due

Tommy saves $1000 at the beginning of each year

for the five years at 8% p.a. How much is the future
value at the end of the 5th year?
4.5 Loan Amortization
 Pure Discount Loans are the simplest form of loan.
The borrower receives money today and repays a
single lump sum (principal and interest) at a future
time.
 Interest-Only Loans require an interest payment each
period, with full principal due at maturity.
 Amortized Loans require repayment of principal
over time, in addition to required interest.

4-59
Pure Discount Loans
 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 12
months 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
4-60
Interest-Only Loan
 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, and we will talk
about them in greater detail later.
4-61
Amortized Loan with Fixed Principal
Payment
 Consider a $50,000, 10 year loan at 8%
interest. The loan agreement requires the firm
to pay $5,000 in principal each year plus
interest for that year.
 Click on the Excel icon to see the amortization
table

4-62
Amortized Loan with Fixed Payment
 Each payment covers the interest expense plus 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

4-63
4.6 What Is a Firm Worth?
 Conceptually, a firm should be worth the
present value of the firm’s cash flows.
 The tricky part is determining the size, timing,
and risk of those cash flows.

4-64
Quick Quiz
 How is the future value of a single cash flow
computed?
 How is the present value of a series of cash flows
computed.
 What is the Net Present Value of an investment?
 What is an EAR, and how is it computed?
 What is a perpetuity? An annuity?

4-65