Chapter 6
Discounted Cash
Flow Valuation
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Key Concepts and Skills
• Be able to compute the future value of
multiple cash flows
• Be able to compute the present value of
multiple cash flows
• Be able to compute loan payments
• Be able to find the interest rate on a loan
• Understand how interest rates are quoted
• Understand how loans are amortized or
paid off
6C-2
Chapter Outline
• Future and Present Values of
Multiple Cash Flows
• Valuing Level Cash Flows: Annuities
and Perpetuities
• Comparing Rates: The Effect of
Compounding
• Loan Types and Loan Amortization
6C-3
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?
FV = 1,248.05
6C-4
Multiple Cash Flows –
Example 1 Continued
• How much will you have in 5 years if you make
no further deposits?
FV = 1,616.26
6C-5
Multiple Cash Flows – PV
Another Example
• 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?
PV = 4,815.93
6C-6
Decisions, Decisions
• Your broker calls you and tells you that he has this 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?
– NPV = 91.49
**No – the broker is charging more than you would be
willing to pay.
6C-7
Annuities and Perpetuities
Defined
• Annuity – finite series of equal payments
that occur at regular intervals
– If the first payment occurs at the end of the
period, it is called an ordinary annuity
– If the first payment occurs at the beginning of
the period, it is called an annuity due
• Perpetuity – infinite series of equal
payments
6C-8
Annuities and Perpetuities –
Basic Formulas
• Perpetuity: PV = C / r
• Annuities:
1
1
(1 r ) t
PV C
r
(1 r ) t 1
FV C
r
6C-9
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
6C-10
Annuity – Example 6.5
• You borrow money TODAY so you
need to compute the present value.
– 48 N; 1 I/Y; -632 PMT; CPT PV =
23,999.54 ($24,000)
• Formula:
1
1 (1.01) 48
PV 632 23,999.54
.01
6C-11
Annuity – Sweepstakes
Example
• Suppose you win the Publishers
Clearinghouse $10 million sweepstakes.
The money is paid in equal annual end-of-
year installments of $333,333.33 over 30
years. If the appropriate discount rate is
5%, how much is the sweepstakes
actually worth today?
– 30 N; 5 I/Y; 333,333.33 PMT; CPT PV =
5,124,150.29
6C-12
Finding the Payment
• Suppose you want to borrow $20,000
for a new car. You can borrow at 8%
per year, compounded monthly (8/12
= .66667% per month). If you take a
4-year loan, what is your monthly
payment?
– 4(12) = 48 N; 20,000 PV; .66667 I/Y;
CPT PMT = 488.26
6C-13
Finding the Number of
Payments – Another Example
• Suppose you borrow $2,000 at 5%, and
you are going to make annual payments
of $734.42. How long before you pay off
the loan?
– Sign convention matters!!!
– 5 I/Y
– 2,000 PV
– -734.42 PMT
– CPT N = 3 years
6C-14
Finding the Rate
• Suppose you borrow $10,000 from your
parents to buy a car. 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 = .75%
6C-15
Annuity – Finding the Rate
Without a Financial Calculator
• Trial and Error Process
– Choose an interest rate and compute the PV of the
payments based on this rate
– Compare the computed PV with the actual loan
amount
– If the computed PV > loan amount, then the
interest rate is too low
– If the computed PV < loan amount, then the
interest rate is too high
– Adjust the rate and repeat the process until the
computed PV and the loan amount are equal
6C-16
Future Values for Annuities
• Suppose 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?
– Remember the sign convention!!!
– 40 N
– 7.5 I/Y
– -2,000 PMT
– CPT FV = 454,513.04
6C-17
Annuity Due
• You are saving for a new house and you put
$10,000 per year in an account paying 8%. The
first payment is made today. How much will you
have at the end of 3 years?
– 2nd BGN 2nd Set (you should see BGN in the display)
– 3N
– -10,000 PMT
– 8 I/Y
– CPT FV = 35,061.12
– 2nd BGN 2nd Set (be sure to change it back to an
ordinary annuity)
6C-18
Annuity Due Timeline
0 1 2 3
10000 10000 10000
32,464
35,016.12
6C-19
Table 6.2
6C-20
Effective Annual Rate (EAR)
• This is the actual rate paid (or received)
after accounting for compounding that
occurs during the year
• If you want to compare two alternative
investments with different compounding
periods, you need to compute the EAR
and use that for comparison.
6C-21
Annual Percentage Rate
• This is the annual rate that is quoted by law
• 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
• You should NEVER divide the effective
rate by the number of periods per year – it
will NOT give you the period rate
6C-22
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%
6C-23
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
6C-24
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 = 1(1.01)12 = 1.1268
• Rate = (1.1268 – 1) / 1 = .1268 = 12.68%
• Suppose you put it in another account and earn
3% per quarter.
– What is the APR? 3(4) = 12%
– How much are you effectively earning?
• FV = 1(1.03)4 = 1.1255
• Rate = (1.1255 – 1) / 1 = .1255 = 12.55%
6C-25
EAR - Formula
m
APR
EAR 1 1
m
Remember that the APR is the quoted rate, and
m is the number of compounding periods per year
6C-26
Decisions, Decisions II
• 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:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
– Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%
• Which account should you choose and why?
6C-27
Decisions, Decisions II
Continued
• Let’s verify the choice. Suppose you invest
$100 in each account. How much will you
have in each account in one year?
– First Account:
• 365 N; 5.25 / 365 = .014383562 I/Y; 100 PV; CPT FV =
105.39
– Second Account:
• 2 N; 5.3 / 2 = 2.65 I/Y; 100 PV; CPT FV = 105.37
• You have more money in the first account.
6C-28
Computing APRs from
EARs
• If you have an effective rate, how can you
compute the APR? Rearrange the EAR
equation and you get:
APR m (1 EAR)
1
m
-1
6C-29
APR - Example
• Suppose you want to earn an effective
rate of 12% and you are looking at an
account that compounds on a monthly
basis. What APR must they pay?
APR 12 (1 .12) 1 / 12
1 .1138655152
or 11.39%
6C-30
End of Chapter
6C-31