Chapter 5
Discounted Cash Flow Valuation
Key Concepts and Skills
• Know how to compute the future value of
multiple cash flows
• Know how to compute the present value of
multiple cash flows
• Know how to compute loan payments
• Know how to find the interest rate on a
loan
• Know how loans are amortized
• Understand how interest rates are quoted
Chapter Outline
• Future and Present Values of Multiple
Cash Flows
• Annuities and Perpetuities
• Comparing interest rates: The Effect of
Compounding
• Loan Types and Loan Amortization
Multiple Cash Flows – FV Example 1
• Suppose you invest $500 in a mutual fund
today and $600 in one year. If the fund
pays 9% annually, how much will you have
in two years?
• -500 PV 9i 2N Compute FV 594.05
• -600 PV 9i 1N Compute FV 654.00
• Add 1248.05
Multiple Cash Flows – FV Example 2
• You deposit $100 into an account in one
year and $300 into the account in 3 years
earning 8% interest. How much will you
have in five years?
• -100PV 8i 4N Compute FV 136.05
• -300PV 8i 2N Compute FV 349.92
• Add 485.97
Example 2 Timeline
0 1 2 3 4 5
100 300
136.05
349.92
485.97
Multiple Cash Flows - PV Example 1
• An investment will pay you $200 in one year,
$400 in two years, $600 the next year, and $800
at the end of the next year.
• You can earn 12% on similar investments. How
much would you pay for this one?
200FV 12i 1N Compute PV
Repeat for years 2, 3, and 4 adjusting the N
number for the number of years
Answer: $1,432.93
Example 1 Timeline
0 1 2 3 4
200 400 600 800
178.57
318.88
427.07
508.41
1,432.93
Multiple Cash Flows –
PV Example 3
• You are considering an investment that will
pay you $1,000 in one year, $2,000 in two
years and $3,000 in three years. If you
want to earn 10% on your money, how
much would you be willing to pay?
1000 FV 10i 1N Compute PV 909.09
2000 FV 10i 2N Compute PV 1,652.89
3000 FV 10i 3N Compute PV 2,253.94
PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.92
Caveat Emptor!
• A stockbroker calls you and tells you that he has
a great investment opportunity. If you invest
$100 today, you will receive $40 in one year and
$75 in two years. If you require a 15% return on
investments of this risk, should you take the
investment?
• How do we solve this?
Bad Broker Advice!
• 40FV 1N 15i Compute PV
• 75FV 2N 15i Compute PV
• 34.78 + 56.71 = 91.49
• You do not make the investment because
in Management 133 you learned how to
evaluate an investment!
• Broker
Annuities and Perpetuities
• Annuity – a pattern of equal payments
that occur at regular intervals
– Ordinary Annuity: when the first payment
occurs at the end of the period
– Annuity Due: when the first payment
occurs at the beginning of the period
• Remember your ABCs
• A B C D: Annuity Due occurs at the Beginning
– Perpetuity – infinite series of equal
payments
Annuities and the Calculator
• You can use the PMT key on the
calculator for the equal payment
• The sign convention still holds
• Ordinary annuity versus annuity due
– You can switch your calculator between
the two types by using the 2nd BGN 2nd Set
on the TI BA-II Plus
– If you see “BGN” or “Begin” in the display
of your calculator, you have it set for an
annuity due
– Most problems are ordinary annuities
Annuity – Lottery Example
• Congratulations! You won $10 million in the
lottery. The money is paid in equal annual
installments of $333,333.33 over 30 years. If
the discount rate is 5%, how much is the
sweepstakes actually worth today?
– PV = 333,333.33[1 – 1/1.0530] / .05 =
5,124,150.29
– 333,333.33PMT 5i 30N Compute PV
Annuity vs. Annuity Due
• Suppose an annuity due has five payments of
$400 each with a 10% discount rate. Compute
the PV of an ordinary annuity and the annuity
due.
• Ordinary:
• 400PMT 4N 10i Compute PV 1,267.95
• Annuity Due:
• 400PMT 5N 10i Compute PV 1,667.95
• Hint: Be sure to adjust calculator for an annuity
due (begin)
Calculating a payment
• You want to borrow $20,000 for a new car.
You qualify for a four-year loan at 8% per
year, compounded monthly. What is your
car payment?
• Try it!
Calculating a payment
• -20,000PV
• .66667i (8%/12)
• 48N (4 years x 12)
• Compute PMT
• Answer: 488.26
Finding the Number of Payments
Credit Card Debt
• You charged $1000 on your credit card for
spring break. You can only afford to make
the minimum payment of $20/month. The
interest rate is 1.5%/month.
• How long will it take to pay for spring
break?
• Try it!
Credit Card Debt Solution
• 1000 PV
• -20 PMT
• 1.5 i
• Compute N
• Answer: 93.11
• 93.11 what? How does that translate to
years?
Finding the Number of Payments
For a Personal Loan
• You borrow $2000 from a friend at 5%
interest rate. You agree to make annual
payments of $734.42.
• How long will it take you to pay off the
loan?
• Try it!
Finding the Number of Payments –
Another Example
• The hard way to solve this problem!
– 2000 = 734.42(1 – 1/1.05t) / .05
– .136161869 = 1 – 1/1.05t
– 1/1.05t = .863838131
– 1.157624287 = 1.05t
– t = ln(1.157624287) / ln(1.05)
The Easy Solution Using Your
Financial Calculator!
• 2000PV
• -734.42 PMT
• 5i
• Compute N
• Answer: Three years
Finding the Rate
• Suppose you borrow $10,000 from your rich uncle
for a trip to Hawaii! You agree to pay $207.58 per
month for 60 months. What is the monthly interest
rate?
– Sign convention matters!!!
60 N
10,000 PV
-207.58 PMT
CPT I/Y
Answer: .75 per month
Future Values for Annuities
• You decide you want to retire at 40, so
you begin saving for your retirement by
depositing $2,000 per year in an IRA.
• If the interest rate is 7.5%, how much
will you have in 40 years?
• Which annuity will have produce the
most amount of money for retirement,
an Ordinary Annuity or an Annuity
Due?
Annuity Solution
– FV(Ordinary) = 454,513.04
– FV(Due) = 488,601.52
– 2000 PMT 7.5i 40N Compute FV
– Change calculator to BEGIN mode for Annuity Due
– All things being equal, the annuity due will always
have the higher dollar amount because the money
has a longer time to compound.
– Remember, the greatest law in the universe is the law
of compound interest!
Perpetuity
• A perpetuity is a annuity with an infinite
life, making continual annual payments
• Perpetuity formula: PV = C/r
– C = Cash flow
– r = return
A perpetual cash flow of $500 with an 8% return
would be computed as:
PV = C/r = $500/.08 = $6,250
Effective Annual Rate (EAR)
• This is the actual or true interest rate paid or
earned (received).
• The effective rate reflects the impact of
compounding frequency.
• If you want to compare two alternative
investments with different compounding
periods you must compute the EAR and use
that for comparison.
Annual Percentage Rate
• This is the annual (nominal) rate that must be
disclosed to consumers on credit cards and
on other loans as a result of “truth in lending”
laws.
• By definition APR = period rate times the
number of periods per year
• Consequently, to get the period rate we
rearrange the APR equation:
– Period rate = APR / number of periods per
year
Computing APRs
• What is the APR if the monthly rate is .5%?
– .5(12) = 6%
• What is the APR if the semiannual rate is .5%?
– .5(2) = 1%
• What is the monthly rate if the APR is 12%
with monthly compounding?
– 12 / 12 = 1%
– Can you divide the above APR by 2 to get the
semiannual rate? NO!!! You need an APR based on
semiannual compounding to find the semiannual
rate.
Things to Remember
• You ALWAYS need to make sure that the
interest rate and the time period match.
– If you are looking at annual periods, you
need an annual rate.
– If you are looking at monthly periods, you
need a monthly rate.
• If you have an APR based on monthly
compounding, you have to use monthly
periods for lump sums, or adjust the interest
rate appropriately if you have payments
other than monthly
Computing EARs - Example
• Suppose you can earn 1% per month on $1 invested
today.
– What is the APR? 1(12) = 12%
– How much are you effectively earning?
• FV = -1PV 1i 12N Compute FV = 1.1268
• Rate = 12.68%
• Suppose if you put it in another account, you earn 3%
per quarter.
– What is the APR? 3(4) = 12%
– How much are you effectively earning?
• -1PV 3i 4N Compute FV = 1.1255
• Rate = 12.55%
Compounding Comparison
• You are looking at two savings accounts. One pays
5.25%, with daily compounding. The other pays
5.3% with semiannual compounding. Which account
should you use?
– First account calculator sequence:
– 5.25 shift NOM%, 365 shift P/YR, shift EFF% =
5.3899
– Second account calculator sequence:
– 5.3 shift NOM%, 2 shift P/YR, shift EFF% =
5.3702
• Which account should you choose and why?
Computing Payments with APRs
• Suppose you want to buy Plasma TV that costs
$3500 and the store is willing to allow you to
make monthly payments. The loan period is for
2 years and the interest rate is 16.9% with
monthly compounding. What is your monthly
payment?
– Monthly rate = 16.9 / 12 i
– Number of months = 2(12) = 24 N
– -3500 PV
– Compute pmt 172.88
Future Values with Monthly
Compounding
• Suppose you deposit $50 per month
into an account that has an APR of 9%,
based on monthly compounding. How
much will you have in the account in 35
years?
– Monthly rate = 9/12 i
– Number of months = 35(12) = 420N
– -50 PMT
– Compute FV 147,089.22
Present Value with Daily
Compounding
• You need $15,000 in 3 years for a new
car. If you can deposit money into an
account that pays an APR of 5.5%
based on daily compounding, how
much would you need to deposit?
– Number of days = 3(365) = 1095N
– Daily rate = 5.5 / 365i
– 15,000FV
– Compute PV 12,718.56
Quick Quiz: Part 5
• What is the definition of an APR?
• What is the effective annual rate?
• Which rate should you use to compare
alternative investments or loans?
• Which rate do you need to use in the
time value of money calculations?
Discount Loans – Example
• Treasury bills are 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?
– 10,000FV 7i 1N
– Compute PV = 9,345.79
Interest-Only Loan - Example
• 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
Amortized Loan with Fixed
Payment - Example
• 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 $5000.
– What is the annual payment?
• -5000 PV 4N 8i
• COMPUTE PMT = 1,509.60
Quick Quiz
• What is a pure discount loan? What is
a good example of a pure discount
loan?
• What is an interest-only loan? What is
a good example of an interest-only
loan?
• What is an amortized loan? What is a
good example of an amortized loan?
End of Chapter 5!