Chapter 4

Discounted Cash Flow Valuation

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Asia Global Edition 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
4-2
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?

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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
call the Future Value (FV).
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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.

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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).

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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.

4-7
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?

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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.
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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

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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.
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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
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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.

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Future Value and Compounding
$1.10  (1.40) 5

$1.10  (1.40) 4
$1.10  (1.40) 3
$1.10  (1.40) 2
$1.10  (1.40 )

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5 4-14
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
4-15
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?
FV  C 0  (1  r ) T
$10,000  $5,000  (1.10) T

$10,000
(1.10)  T
2
$5,000
ln( 1.10)T  ln( 2)

ln( 2) 0.6931
T   7.27 years
ln( 1.10) 0.0953
4-16
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%.
FV  C 0  (1  r ) T
$50,000  $5,000  (1  r )
12

$50,000
(1  r ) 
12
 10 (1  r )  101 12
$5,000

r  10 1 12
 1  1.2115  1  .2115
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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

4-18
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?

4-19
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 4-20
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 4-21
4.3 Compounding Periods
Compounding an investment m times a year for
T years provides for future value of wealth:
mT
 r
FV  C0  1  
 m

4-22
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 

4-23
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
FV  $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:
$50  (1  EAR) 3  $70.93
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Effective Annual Rates of Interest
FV  $50  (1  EAR) 3  $70.93
$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.
4-25
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 
4-26
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

4-27
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. 4-28
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 4-29
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 ) (1  r )
2 3

C
PV 
r
4-30
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
4-31
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 4-32
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
4-33
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 ) (1  r )
2 3
(1  r ) T

C 1 
PV  1  T 
r  (1  r )  4-34
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)  4-35
 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
PV1   t
 1
 2
 3
 4
 $323.97
t 1 (1.09) (1.09) (1.09) (1.09) (1.09)

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

0 1 2 3 4 5
$327 .97
PV   $297 .22
0 1.09 4-36
2-36
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 )  
  4-37
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   4-38
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%?
$8,500  (1.07 ) 2  $8,500  (1.07 ) 4 
$8,500  (1.07 )  $8,500  (1.07) 3 
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

0 1 2 3 4 5
$34,706.26 = refer to growing stream of cash flows with a
fixed maturity (formula) 4-39
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.

4-40
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

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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.
4-42
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

4-43
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

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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.

4-45
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?

4-46