EMBA 807 Corporate Finance Dr.

Rodney Boehme

CHAPTER 4: NET PRESENT VALUE

(Assigned problems are 1, 2, 7, 8, 11, 16, 23, 25, 28, 29, 31, 33, 36, 41, 42, 46, 50, and 52)
The title of this chapter may be “Net Present Value”, but it is essentially an introduction (or
review if you have had a prior finance course) of the Time Value of Money concepts.
Nevertheless, the material covered in this chapter is important and essential in order to
understand the content of this course. Students entering this course have a high variance of
financial knowledge. Some have taken finance courses and others are taking their first finance
course. As a result, these notes are written to accommodate all.
One period models (for now, periods are one year units):
Example 1: You have $1000 cash now (t=0) → therefore, the Present Value or
PV0 = $1000. Let the cost of capital or interest rate be r=11% per year. What is
the Future Value or FV1 of this amount exactly one year from today at t=1? Here
we say that n=1 year.

FV1 = PV0[1 + r] = 1000[1 + 0.11] = $1110.00

Practical interpretation: $1000 in a bank account earning r=11% will earn $110 interest over one year. Final
amount in account is $1110.00.

Example 2: You want to have exactly $1000 in your account exactly one year
from today. The account earns an interest rate r=9% per year. How much must
you have in this account today (t=0) in order to have $1000 at t=1.

We thus have FV1 = $1000. Given r=9% and n=1 year, we must fine PV0.

From above: FV1 = PV0[1 + r] , rearrange to obtain → PV0 = FV1/[1 + r]

PV0 = FV1/[1 + r] = 1000/[1 + 0.09] = $917.43 (this is known as discounting)

Practical interpretation: If $917.43 earns r=9% for one year, it grows to $1000.

Multiperiod examples (number of annual periods n is greater than 1):

We have these following basic formulas: FVn = PV0[1 + r]n (compounding)
PV0 = FVn/[1 + r]n (discounting)
r = [FVn/PV0]1/n –1
n = ln(FVn/PV0)/ln(1+r)
Note that all formulas on this page (single and multiperiod) pertain to lump sum
amounts, i.e., one amount today at t=0 and one amount at a future time t=n, where
n is measured in years, and r is an annual effective rate of interest.

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Example 3: You deposit $500 into an account today that earns r=11% annual
interest. The money is left in the account for n=5 years. What amount FV5 is in
the account 5 years from today?

FVn = PV0[1 + r]n → FV5 = 500[1 + 0.11]5 = 500[1.6851] = $842.53

Note: FV5 = PV0[1 + r][1 + r][1 + r][1 + r][1 + r] = PV0[1 + r]5

Example 4: You own a bond that pays one future cash flow of $100,000 exactly
20 years from today. The applicable annual interest rate over this horizon is
r=6.75%. What is this bond or financial claim worth today (t=0)?

Here, FV20 = $100,000 and n = 20 years. Find PV0 by discounting the FV20 back
to today (t=0).

→ PV0 = FVn/[1 + r]n = FV20/[1 + 0.0675]20 = 100,000/3.69281 = $27,079.61

Note: $27,079.61 deposited into account for 20 years at r=6.75% will grow to $100,000 at t=20 years.

Example 5: A stock index is at 7900 today. It was at 800 exactly 15 years ago.
What was the annualized rate of return for this 15-year horizon?

Here, FV15 = 7900, PV0 = 800, and, of course, n = 15 years. Find r

→ r = [FV15/PV0]1/15 – 1 = [7900/800]1/15 – 1 = 0.164937 or 16.4937%

Note: annualized return and geometric average (Chapter 9) are the same and are used to report investment
performance (mutual funds report this in their prospectus). Also note that the Dow Jones Industrial Average or
DJIA was 800 and 7900 in August 1982 and August 1997, respectively. Therefore, the annualized rate of return was
16.493% for this 15-year period. You can say that we are dealing with PV1982 and FV1997 in this example.

Calculator method of solving Example 5: Enter the following;

FV = 7900
PV = –800, the PV must be of the opposite sign of the future value, otherwise you
will receive an error message. Think of the cash flows as having
opposite flows; you pay 800 and later receive 7900. (it really does not
matter which one is positive or negative here, just as long as you enter
them into the calculator as opposite signs.
N = 15
P/Y = 1 interest compounding period per year (the calculator default is P/Y = 12)1.
Solve for I = 16.493%

1
Once you set P/Y, it stays there until you later manually change the setting or remove the batteries.

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Streams of uneven cash flows:

The following time line illustrates five individual cash flows, beginning now at t=0
and ending at t=4 years. Let the applicable interest rate r=10% per year.
t=0 t=1 t=2 t=3 t=4

CF0 = -50 CF1 = 15 CF2 = 20 CF3 = 20 CF4 = 15

Example 6: Calculate the current Present Value or PV0 of this stream of cash
flows. Especially note that this cash flow stream resembles a business project that
costs $50 now and produces four future cash flows.

We calculate the PV0 of each of the individual five cash flows and then sum them
to obtain the PV0 of this uneven cash flow stream.

PV0 = CF0/(1+r)0 + CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4

PV0 = -50/(1+0.1)0 + 15/(1+0.1)1 + 20/(1+0.1)2 + 20/(1+0.1)3 + 15/(1+0.1)4

PV0 = -50 + 13.6363 + 16.5289 + 15.0263 + 10.2452 =$5.4368

If this were a business project or real investment, then the Net Present Value or
NPV would be $5.44. The interpretation is that the future cash inflows are $5.44
more valuable than the $50 cash outflow required today at t=0, i.e., you spend $50
today to create an asset that is instantly worth $55.44.

Calculator method: This is a major short cut. The procedure varies across
calculators but resembles the following:
C0 = -50
C1 = 15
C2 = 20
C3 = 20
C4 = 15
Then enter I = 10%. Use the NPV key or function to obtain $5.4368

Example 7: Calculate the Future Value or FV4 of the following stream of cash
flows. Let the applicable interest rate r=7% per year.
t=0 t=1 t=2 t=3 t=4

CF0 = 90 CF1 = 60 CF2 = 50 CF3 = 70 CF4 = 80

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One practical application of this example is to make five deposits into an

investment account. The first deposit is made today (t=0) and the fifth and final
deposit is made four years from today at t=4.

We just treat this problem as five separate investments into an account. In other
words, we calculate the FV4 of each of these five cash flows. The first deposit at
t=0 earns annually compounded interest for n = 4 years, the second deposit at t=1
earns annually compounded interest for n = 3 years, and so on. The fifth and final
deposit is made at t=4 and obviously earns zero interest.

FV4 = CF0(1+r)4 + CF1(1+r)3 + CF2(1+r)2 + CF3(1+r)1 + CF4(1+r)0

FV4 = 90(1+0.07)4 + 60(1+0.07)3 + 50(1+0.07)2 + 70(1+0.07)1 + 80(1+0.07)0

FV4 = 117.9716 + 73.5026 + 57.2450 + 74.9000 + 80 = $403.6192

Calculator method: First find the PV0 of the stream of cash flows. Next, take this
PV0 and compound it up to t=4 at r=7%: FV4 = PV0[1+r]4 . Calculators do not
have any function that computes the FV of a cash flow stream.

Perpetuities:
A perpetuity is an infinite stream of constant cash flows, occurring at equal
intervals. The following time line illustrates a perpetuity of $5 per year.

t=0 t=1 t=2 t=3 t=4

CF1 = 5 CF2 = 5 CF3 = 5 CF4 = 5

The formula for the Present Value of a perpetuity is: PV0 = CF/r. This equation
calculates the PV of an infinite stream of equal cash flows.

Example 8: Calculate the current Present Value or PV0 of the above perpetuity.
Let the applicable interest rate r=6% per year.

PV0 = CF/r = 5/0.06 = $83.3333. Therefore, a share of preferred stock that pays a
dividend of $5 per year should sell for $83.33 if the required rate of return is r=6%
per year.

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Growing perpetuity or Gordon Constant Growth Model:

This refers to a cash flow stream that grows at a constant annual growth rate g.
The following time line illustrates such a cash flow stream.
t=0 t=1 t=2 t=3 t=4

CF1 CF2 = CF3 = CF4 =

CF1(1+g) CF1(1+g)2 CF1(1+g)3

Here, CF3 = CF1(1+g)(1+g) = CF1(1+g)2

The constant growth model formula is: PV0 = CF1/(r-g)

Note the timing difference between the cash flow and the PV in the model!
The cash flow CF1 is always one period ahead of the PV0 you are calculating.

The rate of return r must be greater than the annual cash flow growth rate g in
order to use this formula. The growth rate g can be negative, as well.

The constant growth model is an extremely important formula and will be used
extensively in this course. This time value of money formula or tool is used in
nearly every stock valuation example. Note that if there is a cash flow CF0 that has
not yet been paid out, then use: PV0 = CF0 + CF1/(r-g)

Example 9: Trillium is a mature corporation.2 Trillium common stock has just

paid a cash flow of CF0 = $2.00 per share.3 An analyst estimates that Trillium’s
cash flows will grow at a constant annual growth rate of g=5.5% per year forever.
Based on the risk of this stock, investors expect or require an annual rate of return
of r=10% per year. Based on this estimate, what is this stock’s current value?

We must use: PV0 = CF1/(r-g). Note that CF0 has been paid out and is no longer
part of Trillium or it’s stock price. The stock’s value should be the Present Value
of all future expected cash flows. CF0 is no longer a future cash flow.

We need CF1, but we are only given CF0, r, and g. However, CF1 is easily found:

CF1 = CF0(1+g) = 2(1+0.055) = $2.11 per share. Now we can find PV0.

PV0 = CF1/(r-g) = 2.11/(0.10 – 0.055) =2.11/0.045 = $46.89 per share

2
Mature firms are the only firms that can be considered to have a constant growth rate from today forward.
However, when we cover stock valuation in Chapter 5, we state that all firms must mature someday.
3
Firms pay out cash in the form of (1) dividends and (2) stock repurchases. For stock valuation, what matters is
how much can be paid out. How it is paid should not matter, as far as determining what the firm is worth.

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An additional note concerning the constant growth model before we move on. Say
that a firm will pay CF2020 in the year 2020. What will the firm be worth in 2019,
just after the year 2019 cash flow is paid out?

Answer: it will be worth PV2019 = CF2020/(r-g). The one year timing difference
between the PV and CF never change with this model!

Annuities:
An annuity is a finite stream of equal cash flows, occurring at equal intervals. It
does not matter if the payments are being paid out or received, just as long as the
payments are all in the same direction. The following is an example of a six-year
(n=6) ordinary annuity consisting of six $50 payments.
t=0 t=1 t=2 t=3 t=4 t=5 t=6

C = 50 C = 50 C = 50 C = 50 C = 50 C = 50

Since this is a cash flow stream, the PV0 and FV6 can easily be found by using the
procedure covered earlier for uneven cash flows. This can be long and tedious.
However, since these annuity payments are not uneven, we have shortcuts for PV0
and FVn. The following two formulas are for the FVn and PV0 of an ordinary
annuity. Note: with an ordinary annuity, the first cash flow is always at t=1.
1 1 
PV0 = C  - 
 r r (1 + r ) 
n

 (1 + r )n 1 
FVn = C - 
 r r 

Example 10: Let r=10% per year. Calculate the Present Value or PV0 of the
above six year annuity. Essentially, how much would you pay today (t=0) in order
to receive this six year annuity of cash flows?4
1 1   1 1 
PV0 = C  -  = 50  -  = $217.76
 r r (1 + r )   0.1 0.1(1 + 0.1) 
n 6

Long method: PV0 = 50/(1+0.1) + 50/(1+0.1)2 + 50/(1+0.1)3 + 50/(1+0.1)4 + 50/(1+0.1)5 + 50/(1+0.1)6 = $217.76

Calculator method:
PMT = 50

4
You can also think of the PV0 as how much you should deposit today in order to withdraw $50 for each of the next
six years, so that the account is empty after the sixth or last $50 withdrawal.

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I = 10%
N=6
P/Y = 1
Solve for PV = -217.76 (PV will be the opposite sign of the payment)

Example 11: Let r=10% per year. Calculate the Future Value or FV6 of the above
six-year annuity. Essentially, if you make six $50 deposits into an account, the
first and sixth (last) payments being made at t=1 and t=6 years, respectively, how
much money will be in the account in six years (t=6)?
 (1 + r )n 1   (1 + 0.1)6 1 
FVn = C -  = 50  -  = $385.78
 r r   0.1 0.1 

Calculator method:
PMT = -50 (sign does not really matter here, but FV will be of opposite sign)
I = 10%
N=6
P/Y = 1
Solve for FV = 385.78 (positive here since PMT was made negative)

Growing annuities:
Basically, this is a finite series of cash flows that grows at a constant annual rate.
While the Gordon constant growth model discussed earlier is infinite, the growing
annuity is finite.
t=0 t=1 t=2 t=3 t=4

CF1 CF2 = CF3 = CF4 =

CF1(1+g) CF1(1+g)2 CF1(1+g)3

This concept is great for investment planning. The PV0 and FVn equations are:
 1   1+ g  
n
PV0 = C1   1 -   , where C1 is the CF1 on the above timeline
 r - g    1 + r  

 1   1+ g  
n
FVn = C1   1 -    (1 + r )n
 r - g   1 + r  

Example 12: Let r=11% per year. You deposit $2000 into an account exactly one
year from today at t=1. The amount you deposit will grow by g=8% each year.
You will make 30 yearly deposits, the final deposit is 30 years from today at t=30.
How much money will be in the account at t=30 years?

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   1 + 0.08 
30 
 1
FV30 = 2000  1 -  1 + 0.11   (1 + 0.11)30 = $855,309.31
 0.11 - 0.08     

While this seems like a large amount, remember that this is an amount 30 years
into the future, and it does not have the purchasing power of $855,309 today.

Deferred annuities: (highly prone to errors and mistakes!)

When the first payment of an annuity begins more than one period from now, we
call it a deferred annuity. Let us consider the annuity on the following time line.
We have an annuity of n=14 payments of $10,000 each. The first payment is 37
years from today, and the 14th and final payment is 50 years from today.
t=0 t=1 t=36 t=37 t=49 t=50

CF = CF = CF =
10,000 10,000 10,000

Calculate the current Present Value or PV0 of this deferred annuity. There are
actually several methods or procedures that will work here. I present the most
common method below.

Step 1: Jump ahead to t=36 or 36 years from now. From the perspective of t=36
years, we would be looking at just an n=14 year ordinary annuity with the first
payment occurring one year or period ahead of that point in time. Calculate the
Present Value of this 14 year annuity at t=36 years. Let r=8% per year.
1 1   1 1 
PV36 = C  -  = 10,000 -  = $82,442.37
 r r (1 + r )   0.08 0.08(1 + 0.08) 
n 14

A good analogy is the following: Thirty six years from now (at t=36), you will
need to have $82,442.37 in an account if you want to make 14 future withdrawals
of $10,000 each, the first amount removed in one year and the last (14th) amount
removed in 14 years (t=50).

Step 2: The Present Value PV36 from Step 1 becomes FV36 in this second step.
This lump sum $82,442.37 amount from Step 1 must be discounted back exactly
36 years at r=8% per year in order to calculate PV0.

→ PV0 = FV36/[1 + r]36 = 82,442.37/[1 + 0.08]36 = $5162.92

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Other than annual interest compounding periods:

Prior to this point in these notes, interest rates were quoted as effective annual
rates, and compounding periods were annual, e.g., r=9% per year.

However, home and car loans calculate the interest monthly. Credit cards calculate
the interest daily. Many contracts use interest rates that not calculated annually.

What if you deposit $1000 today into an account that pays r=4% interest every six
months or semiannually? After six months you will have $1000[1+0.04] = $1040
in the account. After one year (two semiannual periods) you will have
$1000[1+0.04][1+0.04] = $1081.60 in the account.

It is uncommon to see semiannual interest rates quoted. However, we do know

that this account pays 4% interest every six months, and the amount of money in
this account does effectively grow by r=4% every six months.

The convention is to quote rates as annual, even though the compounding periods
may not be annual. Here in our example, the r=4% effective semiannual rate is
thus multiplied by the m=2 semiannual periods per year, and the interest rate will
be quoted as 8% annual nominal, compounded semiannually.

For this particular example we state: (1) rnom=8% and (2) m=2. “rnom” is what we
call the nominal or stated interest rate, and “m” is the number of interest
compounding periods per year. Caveat: while the 8% annual nominal rate is
typically quoted, it is not the effective annual interest rate.

Note that: rnom/m = 8%/2 = 4%. This 4% is the effective semiannual interest rate.
The effective annual interest rate is (1+0.04)(1+0.04) – 1 = 0.0816 or 8.16%, since
here $1 grows to $1.0816 in one year.

Note that the following two equations relate the Present and Future lump sum
values, where m is the number of compounding periods per year, and n is the
number of years.
n ⋅m
 r  FVn
FVn = PV0 1 + nom  and PV0 =
n ⋅m
 m   rnom 
1 + m 
 
Example 13: You deposit $10,000 today into an account that pays 6% annual
nominal interest, compounded quarterly. How much money will be in the account
exactly 10 years from today if no further deposits are made?

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The account will earn rnom/m = 6%/4 = 1.5% interest every 3 months for n·m =
(10)(4) = 40 quarterly periods.
n ⋅m 10⋅4
 r   0.06 
FVn = PV0 1 + nom  = 10,000 1 + = $18,140.18
 m   4 

Example 14: You want to have $20,000 in an account 5 years from today. The
account pays 6% nominal interest, compounded quarterly. How much should you
deposit today in order to have $20,000 in 5 years (n=20 quarterly payments)?
FVn 20,000
PV0 =
n ⋅m
= 5⋅4
= $14,849.41
 rnom   0.06 
1 + m  1 + 4 
   

Converting nominal to effective rates:

In Examples 13 and 14, the interest rate was rnom of 6% annual nominal,
compounded quarterly. The effective quarterly interest rate is just rnom/m = 6%/4 =
1.5% per quarter. The formula to convert nominal to effective rates is given as:
m
 r 
Effective annual rate (EAR) = 1 + nom  −1
 m 

In the case of Examples 13 and 14, calculate the actual effective annual rate of
interest:
m 4
 r   0.06 
Effective annual rate = 1 + nom  −1 = 1 + 4  − 1 = 0.061364 or 6.1364%
 m   

Also, to convert the annual effective rate to an annual nominal rate, given m:
[
rnom = m (reff + 1)1/ m − 1 ]
Example 15: A credit card states that the annual interest rate charged is 18% APR
(annual percentage rate) and that interest charges are calculated daily. APR is a
nominal rate. In this example, the interest rate being quoted is 18% annual
nominal, compounded daily. What is the annual effective rate of interest?
m 365
 r   0.18 
Effective annual rate = 1 + nom  −1 = 1 + 365  −1 = 0.197164 or 19.7164%
 m   

Example 16: $20,000 is borrowed today to finance a car purchase. The car loan is
for 48 months. The loan contract states the interest rate as 10% APR, and the
loan’s interest charges and payments are made monthly. The amount of each

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monthly payment is identical. Calculate the effective annual interest rate and the
monthly payment on this loan.

The interest rate quoted here is 10% annual nominal, compounded monthly.
m 12
 r   0.10 
Effective annual rate = 1 + nom  −1 = 1 + 12  −1 = 0.104713 or 10.4713%
 m   

Note: here the effective monthly interest rate is rnom/m = 10%/12 = 0.83333% per
month.

The 48 month car loan is a 48 period annuity, consisting of 48 monthly payments

or periods. Note the following annuity formula (it is similar to what we covered
earlier in the introduction to annuities).
 
 
1 1
PV0 = C  - 
n ⋅m 
 rnom r  r 
 m nom m 1 + nom m  
   

The amount borrowed today, $20,000, is the PV0.

 
 1 1 
20,000 = C  - → 20,000 = C[39.42819] → C = $507.25
0.1
( 48
 12 0.112 1 + 0.112 

)
Calculator method:
PV = 20,000
I = 10% (the nominal annual rate of interest)
N = 48 (there are 48 periods or payments in this annuity’s life)
P/Y = 12 (the calculator takes the inom=10% and divides it by m or P/Y=12 so it can
solve the annuity using a monthly effective rate of 0.83333% per month)
Solve for PMT = -507.25 (negative here since PV was made positive)

Alternative calculator method:

PV = 20,000
I = 0.83333% (the effective monthly rate of interest)
N = 48 (there are 48 periods or payments in this annuity’s life)
P/Y = 1
Solve for PMT = -507.25

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