Chapter 4

DISCOUNTED CASH FLOW VALUATION

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

KEY CONCEPTS AND SKILLS

Appreciate the significance of compound vs. simple
interest
Describe and compute the future value and/or present
value of a single cash flow or series of cash flows
Define and calculate the return on an investment
Recognize and compute the impact of compounding
periods on the true return of stated interest rates
Develop facility with a financial calculator and/or
spreadsheet to solve time value problems
Comprehend and calculate time value metrics for
perpetuities and annuities
Familiarization with loan types and amortization
4-2

CHAPTER OUTLINE
4.1
4.2
4.3
4.4
4.5
4.6

Valuation: The One-Period Case

The Multiperiod Case
Compounding Periods
Simplifications
Loan Types and Loan Amortization
What Is a Firm Worth?

4-3

THE ESSENTIAL PREMISE

A dollar today is more valuable than a dollar to be
received in the future
Why?
A dollar today is more valuable because:
It can be invested to make more dollars
It can be immediately consumed
There is no doubt about its receipt

4-4

AN IMPORTANT COROLLARY
If you know your required rate of return and the
length of time before cash is harvested, you can
calculate some critical metrics:
The value today of a payment to be received in
the future
This measure is called a Present Value

The value in the future of a sum invested today

This measure is called a Future Value

Present and Future Values can be calculated

over single and multiple periods
4-5

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).
4-6

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.

4-7

,$9,523.8.5
$
1
0
PRESENT VALUE

Present Value is todays value of a sum to be received

in the future given a specific rate of interest and time
horizon.
Suppose you were promised $10,000 due in one year
when interest rates are 5-percent. Your investment be
worth $9,523.81 in todays dollars.

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 the
Present Value (PV).
Note that $10,000 = $9,523.81(1.05).

4-8

C
1r
P
V
1

PRESENT VALUE

In the one-period case, the formula for PV can be

written as:

Where C1 is cash flow at date 1, and

r is the appropriate interest rate.

4-9

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?
4-10

$
1
0
,
N
P
V

$239.,8509.25381

NET PRESENT VALUE

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.

4-11

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
4-12

4.2 THE MULTIPERIOD CASE

The previous examples considered only one
period of time.
It is possible to compute PV & FV for multiple
periods of time.
Doing so requires discrimination between simple
and compound interest

4-13

SIMPLE INTEREST
Suppose an investor has $1,000 to invest at an
interest rate of 9%
In one year, they will have earned $90
[=1000 x (1+.09)]

If they take the $90 earned out of the capital market

and reinvest the $1,000 capital at 9% they will again
earn $90 in a years time.
This process could continue ad infinitum with the
annual earnings never contributing further to the
investors wealth
With simple interest, therefore, valuing future or
present values never has to extend beyond the single
period case
4-14

COMPOUND INTEREST
Suppose an investor has $1,000 to invest at an interest
rate of 9%
In one year, they will have earned $90 (=1000 x .09)
Now suppose that the investor reinvests both the original
$1,000 capital AND $90 earnings for another year at 9%
In one year they will have earned $98.10, an amount $8.10
greater than the previous year.
In this example, the interest in the second year is higher
than the first because it is paid on the initial capital AND
prior earnings.
In other words, the earnings also earn interest or are
compounded
Compounding may not seem very compelling the early
years of an investment. But, we will see that it is a very
powerful long term force
4-15

MULTIPERIOD FUTURE VALUE

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.

4-16

EXAMPLE: MULTIPERIOD 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

4-17

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.

4-18

5
.$1.05(24$
(2
$
)).31
1
0

4
4
6$3.02$4.23$5.92

FUTURE VALUE AND COMPOUNDING

4-19

MULTIPERIOD PRESENT VALUE

The general formula for the present

value of an investment over many
periods can be written as:
PV = CT / (1 + r)T

Where
CT is cash flow at date T,
r is the appropriate interest rate, and
T is the number of periods over which the
cash is invested.

4-20

,$9,43.5(1.5)5
$
2
0
EXAMPLE: MULTIPERIOD 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
0

$20,000

4-21

SOLVE FOR ANY VARIABLE

Examples thus far have offered the time and
interest rate and solved for PV or FV
Keep in mind that there are four variables:

PV
FV
T
R

If you have any three you can solve for the fourth
The math can become cumbersome
Financial calculators and spreadsheets are very helpful

4-22

F
VC
(1lnr).0$ln1(02,)$5,0(1.0)

T
T
0
$
1
0
,
T
(Tl(n11..200)).T0659317.2years

EXAMPLE: SOLVING FOR TIME

If we deposit $5,000 today in an account paying

10%, how long does it take to grow to $10,000?

4-23

F
VC
(10r)1.$250,(1$.r25),0(1r)

T
1
2
0
,(1r)121012
$
5
0
1
2

EXAMPLE: SOLVING FOR REQUIRED

RETURN

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 childs education?

About 21.15%.

4-24

CALCULATOR ORIENTATION: 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

4-25

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?

4-26

MULTIPLE CASH FLOWS

0

200

400

600

800

178.57
318.88
427.07
508.41
1,432.93

Present Value < Cost Do Not Purchase

4-27

VALUING UNEVEN CASH FLOWS

First, set your calculator to 1 payment per year.
Then, use the cash flow menu:
CF0

CF3

600

CF1

200

F3

NPV

F1

CF4

800

CF2

400

F4

F2

12
1,432.93

4-28

4.3 COMPOUNDING PERIODS

All examples thus far have assumed annual
compounding
Instances of other compounding schedules abound:
Banks compound interest quarterly, monthly or daily
Mortgage companies compound interest monthly
Yet, almost all interest rates are expressed annually
If a rate is expressed annually, but compounded more
frequently, then the effective rate is higher than the
stated rate
This concept is called the Effective Annual Rate or EAR

4-29

r
F
V
C
1m

m
T
0

COMPUTING FV WITH MULTIPLE

COMPOUNDING PERIODS

Compounding an investment m times a

year for T years provides for the future
value of wealth:

4-30

.V
1
2
F
$50 $50(1.6)$70.93

236

COMPOUNDING PERIODS

For example, if you invest $50 for 3 years at 12%

compounded semi-annually, your investment will
grow to

4-31

.F
1
2
3R
V
$50$50((1E
)2A
)3$50$70(1.9.36)6$70.93
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?

The Effective Annual Rate (EAR) of interest is

the annual rate that would give us the same
end-of-investment wealth after 3 years:

4-32

(EAR$7051.933E
F
V

$
5
0

)1135.$7203.693
A
R

EFFECTIVE ANNUAL RATES OF

INTEREST

So, investing at 12.36% compounded annually is

the same as investing at 12% compounded semiannually.

4-33

r .128 (1.05)1.956
1m
m1212

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 of 1%.

This is equivalent to a loan with an annual

interest rate of 19.56%.

4-34

EAR ON A FINANCIAL CALCULATOR

Texas Instruments BAII Plus

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

19.56

4-35

CONTINUOUS COMPOUNDING
The general formula for the future value
of an investment compounded
continuously over many periods can be
written as:
FV = C0erT
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 constant that is approximately equal to 2.718. ex
is a key on your calculator.
4-36

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
4-37

C
C
C
P
V
(1r)(1r)2(1r)3
PERPETUITY

A constant stream of cash flows that lasts forever

4-38


1
5
P
V
.00

PERPETUITY: EXAMPLE
What is the value of a British consol that
promises to pay 15 every year for ever?
The interest rate is 10%.

15

15

15
3

4-39

(
1

g
)
C

(
1

g
)
P
V
(1

rg)rr

2
23

GROWING PERPETUITY

A growing stream of cash flows that lasts forever

C(1+g)

C (1+g)2

4-40

.P
$
1
3
0
V
5$26.0

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)
2

$1.30 (1.05)2

4-41


C
C
C
C
P
V
(1r

)(1r) (1r)(1r)

2
3
T
T

ANNUITY

A constant stream of cash flows with a fixed maturity

4-42


P
V
$
4
0
1
.7/21(.072)$12,954.
36

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

36

4-43

$
1
0
$
1
0
$
1
0
$
1
0
$
1
0
P
V

$
3
2
.
9
7
(.9)(.9)(.9)(.9)(.9)

.P
$
3
2
7
9
V

$
2
9
7
.
010

4
1t1t1234

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%?

$297.22

$323.97

$100

$100

$100

$100

4-44

(
1

g
)
C

(
1

g
)
P
V
(1gr) r
r

1
2T

GROWING ANNUITY

A growing stream of cash flows with a fixed maturity

C(1+g)

C (1+g)2

C(1+g)T-1
T

4-45


V
,P
$
2
0
.13 1.03 $265,1.7
40

GROWING ANNUITY: EXAMPLE

A defined-benefit retirement plan offers to pay

$20,000 per year for 40 years and increase the
annual payment by three-percent each year. What
is the present value at retirement if the discount
rate is 10 percent?

$20,000

$20,000(1.03)
2

$20,000(1.03)39
40

4-46

4.5 LOAN TYPES AND 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.
4-47

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

4-48

INTEREST-ONLY LOANS
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.

4-49

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

4-50

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
4-51

4.6 WHAT IS A FIRM WORTH?

Conceptually, a firm should be worth the present
value of the firms cash flows.
The tricky part is determining the size, timing and
risk of those cash flows.

4-52

A NOTE ABOUT TECHNIQUE

You can solve time value problems in any
of four ways:

Math (Formulae given above)

Tables (See Appendix A)
Financial Calculator
Spreadsheet Software

Financial calculators and spreadsheet

software are the most common methods
now.
4-53

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?
Contrast interest-only loans to amortized
loans.

4-54