4. Discounted Cash Flow Valuation (Amended September 29, 2022)

ADMN 3200 Week 4
Chapter 6 – Discounted Cash Flow Valuation

Agenda
• Brief recap of last week (Chapter 5)
• Chapter 6 – Discounted Cash Flow Valuation
• Weekly deliverables:
• Assignment 4 due October 5 (2%)
Last Week – Key Concepts
• Simple interest vs. compound interest
• Calculate future value (lump sum investment)
• For a single period
• For multiple periods
• Discount cash flows (lump sum cash flow)
• For a single period
• For multiple periods
• Rearrange the cash flow equation to determine PV, FV, r, t
• Future and present values with non-annual compounding
Why Should I Care?
Chapter 6
Discounted Cash Flow Valuation
Future and Present Values of
Multiple Cash Flows
• Last week: Future Value and PV of a single cash flow
• This week, Future Value and PV of a stream of cash flows
• Timelines are a useful tool for conceptualizing today’s content
• We will begin by demonstrating two ways that the Future Value and
PV of a stream of cash flows can be calculated
• Note: these methods are most useful when the stream of cash flows is not
uniform
Multiple Cash Flows
• Example: An analyst estimates that Kramerica Industries
(“Kramerica”) will generate free cash flow (cash flow from assets) of
-$4.0 million, $1.5 million, $15.8 million, and $9.3 million in years 1, 2,
3, and 4, respectively. Kramerica will shut down thereafter. The
analyst estimates an appropriate discount for Kramerica is 23.0%.
What is the present value of the Kramerica cash flows? (Assume all
cash flows happen at the end of each period.)
Multiple Cash Flows
Multiple Cash Flows
Multiple Cash Flows
Valuing Annuities and Perpetuities
• Annuities are a stream of uniform cash flows that occur at consistent
intervals.
• E.g. automobile loans, mortgages, rent
• Ordinary annuity: cash flows occur at the end of the period
• Annuity due: cash flows occur at the beginning of the period
• Example 1: Consumer pays a three-year, $6,000 ordinary annuity for
an automobile loan. The loan bears interest at 7.0% per annum. What
is the PV of the annuity?
• Easy to calculate with the methods discussed earlier.
• For self-study –> answer = $15,746
• Example 2: Consumer pays a 30-year, $34,000 per year ordinary
annuity for their mortgage. The mortgage bears interest at 5.0% per
annum. What is the PV of the annuity?
• Possible, but cumbersome to calculate with the methods discussed. Some
annuities contain hundreds or thousands of payments.
Or:
• C = periodic payment amount
• Note also that
• What if we want to find the required payment amount that will
equate to a desired PV?
• We can rearrange the formula to find this.
Or:
• Example: Mayank purchased a one-bedroom condo in beautiful
downtown Toronto for $1.3 million. Mayank funded the home with a
$0.3 million down payment and a 25-year, $1.0 million mortgage
bearing 4.8% interest per annum, compounded annually. Assuming
Mayank makes one mortgage payment per year, how large will his
payment be?
• What if we want to find the number of required payments that it
would take to pay off an annuity?
• Example: Jay owes $500 on a credit card bearing interest at 20% per
annum, compounded annually. Jay’s minimum annual payment is
$101. If Jay makes only the minimum required payments, how long
will it take to pay off the credit card?
• What if we want to find the required discount rate to equate a given
series of payments to a given PV?
• Not possible by algebra alone. If you don’t believe me, try it for yourself!
• Can be approximated with trial and error. More efficient and precise to use
software, such as Excel.
Valuing Annuities and Perpetuities –
FV of Annuities
• Similarly to PVs, there is an efficient way to find the FV of an annuity:
Or:
FV of Annuities
• Example: Yoram would like to retire in 45 years with $2.0 million in a
brokerage account. Yoram expects the brokerage account to provide a
return of 8.5% per annum. If Yoram makes one uniform payment to
his brokerage account every year, how large should the payment be to
meet his retirement goal?
FV of Annuities
Annuity Due
• If we used the PVIFA to value an annuity due, we would theoretically
be discounting every payment by one period too many.
• The first payment occurs immediately (t=0) so should not be discounted, the
second payment occurs at t=1, … , the nth payment occurs at t = n+1
• We can fix this with either of the following methods:
Annuity Due
Or:
Valuing Annuities and Perpetuities -
Perpetuities
• What if an annuity continues forever?
• We call this a “perpetuity”
• Mathematically very simple compared to finite annuities
• If you want to prove this, consider what would happen when t

approaches infinity in our finite annuity calculation
Perpetuities
• What if a perpetuity is growing?
• g = rate of growth
Perpetuities
• Example: Enbridge is expected to pay a dividend of $3.50 next year.
Thereafter, the dividend is expected to grow at a constant rate of
2.0% per annum. An appropriate discount rate for Enbridge is 12%.
What is the present value of the dividends if they continue forever?
Perpetuities
Growing Annuity
• Note: The first term is the formula for a growing perpetuity. The
second term is the “discount” we apply due to the finite period.
Growing Annuity
• Example: Tiki has just retired. Her pension plan will pay $100,000 in
her first year of retirement, and grow at a rate of 2.0% per annum. An
appropriate discount rate for the pension is 4.0% per annum. What is
the present value of Tiki’s retirement plan if it pays out for 30 years?
Growing Annuity
Comparing Rates: The Effect of
Compounding
• 12% annually is not the same as 1% per month!
• The 1% per month compounds 12 times per year, compared to just once for the
12% per year. So FV (PV) will be higher (lower) using 1% per month
• Often for a rate to be quoted as “10% per year compounded quarterly”. This is
mildly deceptive to an uniformed party. 10% is the “annual percentage rate
(APR)”
• Effective Annual Rate: the annual rate that is equivalent to the stated
interest rate.
• Allows us to easily compare interest rates with different compounding periods
• m = number of periods in a year (assuming r is expressed in years)

Compounding
• Example: Money Mart is advertising a loan with a very low interest
rate of 3.25% per month. What is the effective annual rate of interest?
(Hint: 3.25% = r/m)
• 46.78%
Compounding
• Example: An automobile dealer offers financing at a rate of 6.5% per
annum, compounded semi-annually. What is the effective annual
interest rate?
• 6.61%
Compounding
• What if compounding was continuous?
Compounding
• Example: A credit union offers a line of credit at a rate of 4.0% per
annum, compounded continuously. What is the effective annual rate
of interest?
• 4.08%
Loan Types and Loan Amortization
• Pure Discount Loans
• Borrower receives money today and makes a single lump sum payment at
maturity.
• Easiest type for us to value.
• Interest-Only Loans
• Borrower makes regular payments of interest only.
• Conceptually simple.
Loan Types and Loan Amortization
• Amortized Loans
• Borrower makes regular payments of interest and principal. As the loan approaches
maturity, the portion paid towards interest becomes lower and the portion paid
towards principal becomes higher (assuming the total cash payment is the same).
• Loan might also require repayment of interest + a fixed amount of principal at every
payment. In this case, the dollar amount of payments will decrease over time.
• Loan doesn’t necessarily need to amortize to $0 based on these regular payments.
There may be an additional “bullet” payment at maturity.
• Mortgages are the most typical example.
• Not as conceptually simple, requires creation of an amortization table to
completely understand the changes in principal.
A Note on Timing of Cash Flows
• For the purposes of this class, unless otherwise specified, you can
assume that a cash flow occurs at the end of the period.
• In practice, determining when the cash flow takes place can have
significant impact on the calculated values. Cannot just assume end of
period cash flows.
• For discussion: How would the equations we spoke of today differ if it
is December 31, 20XX, and we are analyzing a stream of payments
that will be made annually on March 31?
• Upcoming:
• McGraw Hill Connect Assignment due Thursday – 2% of final grade, best 8 of
10 will be scored
• Next week: Chapter 7: Interest Rates and Bond Valuation

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ADMN 3200 Week 4

Chapter 6 – Discounted Cash Flow Valuation

• If you want to prove this, consider what would happen when t

• m = number of periods in a year (assuming r is expressed in years)

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