TOPIC 5

VALUATION OF FUTURE CASH FLOWS

Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems
require multiple steps. Due to space and readability constraints, when these intermediate
steps are included in this solutions manual, rounding may appear to have occurred.
However, the final answer for each problem is found without rounding during any step in
the problem.

Q5.6 Calculating Annuity Values. Your company will generate $45,000 in cash flow
each year for the next nine years from a new information database. The computer
system needed to set up the database costs $260,000. If you can borrow the
money to buy the computer system at 8.25 percent annual interest, can you afford
the new system?

PV= ? 45,000 45,000

45,000=PMT
|_______________|___ ___________|_________---
_________| I/Y=8.25%
0 1 2 9
To find the PVA, we use the equation:

t n
PVA = C({1 – [1/(1 + r) ]} / r ) or PVA = PMT({1 – [1/(1 + i) ]} / i )
9
PVA = $45,000{[1 – (1/1.0825) ] / .0825}
PVA = $278,210.88
ND
Calculator: 2 CLR TVM (shown only once)
45000 PMT 8.25 I/Y 9 N CPT PV = 278,210.88

The present value of the revenue is greater than the cost, so your company can
afford the equipment.

Q5.10 Calculating Perpetuity Values. Dawa Financial is trying to sell you an

 investment policy that will pay you and your heirs $35,000 per year forever. If the
required return on this investment is 7 percent, how much will you pay for the
policy?

PV= ? 35,000 35,000=PMT à ∞

|_______________|___ ___________|_____________--
-> ∞ I/Y=7%
0 1 2
This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:
PV ∞ = C / r or PV ∞ = PMT / i
PV ∞ = $35,000 / .07
= $500,000
35000 PMT 7 I/Y 9,999,999 N CPT PV = 500,000

Q5.14 Calculating EAR. First National Bank charges 10.1 percent compounded
monthly on its business loans. First United Bank charges 10.3 percent
compounded semi-annually. As a potential borrower, which bank would you go to
for a new loan?
Note:
APR = annual percentage rate (nominal rate)
= market quoted rate where compounding can be monthly, quarterly etx.
e.g. APR = 12%pa compounded monthly due to monthly PMT
Period rate = APR / number of periods
i.e. Monthly rate = 12% / 12 = 1% per month (used for calculator)

EAR = effective annual rate (effective rate)

= annual compounding rate that is easy to understand and useful for comparison
e.g. EAR = 12%pa compounded yearly due to yearly PMT

For discrete compounding, to find the EAR, we use the equation:

m
EAR = [1 + (APR / m)] – 1 where EAR = effective annual rate
APR = annual percentage rate (nominal rate)
m = frequency of compounding in a year
Note: EAR = compounded once a year
 APR = compounded more than once a year

So, for each bank, the EAR is:

12
First National: EAR = [1 + (0.101 / 12)] – 1 = .1058 or 10.58%
Cal: 2ndF RESET ENTER (shown only once)
2ndF ICONV NOM=10.1 C/Y=12 CPT EFF=10.58%
Actual:
2ndF ICONV NOM=10.1 ENTER ↓↓ C/Y=12 ENTER ↑ CPT EFF=10.58%

PV=100 FV=110.58
|_______________|___ ___________|_________---
_________| I/Y=(10.1/12)%
0 1 2 12
Calculator: 100 PV 10.1÷12= I/Y 12 N CPT FV = 110.58
=>100 PV 10.58 I/Y 1 N CPT FV = 110.58

PV=100 FV=110.58
|___________________________________________
____| I/Y= 10.58%
0 1

2
First United: EAR = [1 + (0.103 / 2)] – 1 = .1057 or 10.57%
Cal: 2ndF ICONV NOM=10.3 C/Y=2 CPT EFF=10.57%
Actual:
2ndF ICONV NOM=10.3 ENTER ↓↓ C/Y=2 ENTER ↑ CPT EFF=10.57%

PV=100 FV=110.57
|_______________|_______________| I/Y=
(10.3/2)%
 0 1 2
Calculator: 100 PV 10.3÷2= I/Y 2 N CPT FV = 110.57
=>100 PV 10.57 I/Y 1 N CPT FV = 110.57

PV=100 FV=110.57
|___________________________________________
____| I/Y= 10.57%
0 1

For a borrower, First United would be preferred since the EAR of the loan is
lower. Notice that the higher APR does not necessarily mean the higher EAR. The
number of compounding periods within a year will also affect the EAR.
Q5.15 Calculating APR. Magnus Credit Corp. wants to earn an effective annual return
on its consumer loans of 16 percent per year. The bank uses weekly compounding
on its loans. What interest rate is the bank required by law to report to potential
borrowers? Explain why this rate is misleading to an uninformed borrower.

The reported rate is the APR, so we need to convert the EAR to an APR as
follows:

m
EAR = [1 + (APR / m)] – 1

1/m
APR = m[(1 + EAR) – 1]
1/52
APR = 52[(1.16) – 1] = .1486 or 14.86%
Cal: 2ndF ICONV EFF=16 C/Y=52 CPT NOM=14.86%
Actual:
2ndF ICONV ↓ EFF=16 ENTER ↓ C/Y=52 ENTER ↓ CPT NOM=14.86%

This is deceptive because the borrower is actually paying annualized interest of

16% per year, not the 14.86% reported on the loan contract.
(i.e. EFF = 16%pa comp yearly, APR = 14.86%pa comp weekly)

Q5.20 Calculating Loan Payments. You want to buy a new sports coupe for $73,800,
and the finance office at the dealership has quoted you an 6.1percent APR loan for
60 months to buy the car. What will your monthly payments be? What is the
effective annual rate on this loan?
PV= 73,800 PMT PMT
PMT
|_______________|___ ___________|_________---
_________| I/Y=6.1/12%
0 1 2 60
We first need to find the annuity payment. We have the PVA, the length of the annuity,
and the interest rate. Using the PVA equation:
N
t
PVA = C({1 – [1/(1 + r) ]} / r )
60
$73,800 = $C[1 – {1 / [1 + (0.061/12)] } / (0.061/12)]

Solving for the payment, we get:

C = $73,800 / 51.6014
C = $1,430.20
Calculator: 73800 PV 6.1÷12= I/Y 60 N CPT PMT = 1,430.20

To find the EAR, we use the EAR equation:

m
EAR = [1 + (APR / m)] – 1
12
EAR = [1 + (0.061 / 12)] – 1
EAR = .0627 or 6.27%
Cal: 2ndF ICONV NOM=6.1 C/Y=12 CPT EFF=6.27%
Actual:
2ndF ICONV NOM=6.1 ENTER ↓↓ C/Y=12 ENTER ↑ CPT EFF=6.27%

Q5.23 Valuing Perpetuities. Mobuto Money Limited is selling a perpetual annuity

contract that pays $3,100 monthly. The contract currently sells for $325,000.
What is the monthly return on this investment vehicle? What is the APR? The
effective annual return?

PV= 325000 3,100 3,100 ---

3,100=PMT
|_______________|___ ___________|______---
_______| I/Y= ?
 0 1 2 ∞
Here we need to find the interest rate that equates the perpetuity cash flows with the PV
of the cash flows. Using the PV of a perpetuity equation:

PV = C / r or PV=PMT/i
$325,000 = $3,100 / r

We can now solve for the interest rate as follows:

r = $3,100 / $325,000
r = .0095 or 0.9538% per month

The interest rate is 0.95% per month. To find the APR, we multiply this rate by
the number of months in a year, so:

APR = (12)0.9538%
APR = 11.45% pa compounded monthly

m
EAR = [1 + (APR / m)] – 1
12
EAR = [1 + (0.1145 / 12)] – 1
EAR = .01201 or 12.01%
Cal: 2ndF ICONV NOM=11.45 C/Y=12 CPT EFF=12.07%
Actual:
2ndF ICONV NOM=11.45 ENTER ↓↓ C/Y=12 ENTER ↑ CPT EFF=12.07%

Q5.28 Discounted Cash Flow Analysis. If the appropriate discount rate for the
following cash flows is 9.29 percent per year, what is the present value of the cash
flows?

Year Cashflow ($)

1 1,800

2 2,300

3 4,500

4 5,100
 PV=? 1800 2300
4500 5100
|_______________|___
___________|______________|______________| I/Y
=9.29%
0 1 2 3 4
To solve this problem, we must find the PV of each cash flow and add them. To
find the PV of a lump sum, we use:

t
PV = FV / (1 + r)
2 3 4
PV = $1,800 / 1.0929 + $2,300 / 1.0929 + $4,500 / 1.0929 + $5,100 / 1.0929
PV = $10,594.61
Financial Calculator:
CF CF0= 0 C01=1800 C02=2300 C03=4500 C04=5100 NPV I=9.29 CPT NPV=
10,594.61
Actual:
CF [2ND CLR WORK] CF0= 0 ↓C01=1800 ENTER ↓↓ C02=2300 ENTER ↓↓
C03=4500 ENTER ↓↓ C04=5100 ENTER NPV I=9.29 ENTER ↓ CPT NPV=
10,594.61

Extra Tutorial Questions

1. You want to borrow $1,000,000 to buy a house. The bank quoted you 12% pa
compounding monthly over 20 years. What are the monthly repayments?

Solutions:

Using calculator;
1,000,000 PV 12÷12=1 I/Y 20x12=240 N COMP PMT = 11,010.86

2. What is the present value of $3,000 in one year, $6,000 in two years and $9,000 in
three years if interest is 10% pa compounded yearly?
Solutions:
Using formula, find PV:
PV = $3,000 / (1.10)1 = $2,727.27
PV = $6,000 / (1.10)2 = $4,958.67
PV = $9,000 / (1.10)3 = $6,761.82
PV = $2,727.27 + 4,958.67 + 6,761.82 = $14,447.76
 or;
Using calculator:
N = 1; I/Y = 10; FV = 3,000; CPT PV = -2,727.27
N = 2; I/Y = 10; FV = 6,000; CPT PV = -4,958.67
N = 3; I/Y = 10; FV = 9,000; CPT PV = -6,761.82
PV = $2,727.27 + 4,958.67 + 6,761.82 = $14,447.76

or;
CF CF0 = 0, CO1 = 3,000 CO2 = 6.000 CO3= 9,000; I/Y = 10, CPT NPV =
$14,447.78

3. You need a loan. Bank A charges you 12.0% p.a. compounded daily while Bank B’s
rate is 1% per month. Which bank should you choose?

Solutions:
Bank A:
365
EAR = [1 + (0.12 / 365)] – 1 = .1275 or 12.75%
or
Cal: 2ndF RESET ENTER
2ndF ICONV NOM=12 C/Y=365 CPT EFF=12.75%
Bank B:
APR = 1% per month x 12 = 12%pa comp monthly
12
EAR = [1 + (0.12 / 12)] – 1 = .1268 or 12.68%
Cal: 2ndF RESET ENTER
2ndF ICONV NOM=12 C/Y=12 CPT EFF=12.68%

He should borrow from Bank B because effective borrowing rate of 12.68% is

lower than Bank A effective rate of 12.75%.

4. How much can you borrow for a business start-up if your bank loan repayments are
5 equal instalments of RM20,000 per year. Interest quoted by the bank concerned
is 1% per month.

Solutions:

PV=? 20,000 20,000

20,000=PMT
|_______________|___ ___________|______---
______| I/Y= ?
0 1 2
5
 First, convert the monthly rate to a yearly rate (EAR):
APR = 1% per month x 12 = 12%pa comp monthly
12
EAR = [1 + (0.12 / 12)] – 1 = .1268 or 12.68%
Cal: 2ndF RESET ENTER
2ndF ICONV NOM=12 C/Y=12 CPT EFF=12.68%

Now calculate the borrowed sum:

2ndF CLR TVM
20000 PMT 12.68 I/Y 5 N CPT PV = 70,897.35

Therefore, your borrowed sum is RM70,897.35 for your start-up.