Discounted Cash Flow Valuation

Chapter 5
 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 loans are amortised or paid off
• Understand how interest rates are quoted

5-1
 Chapter Outline
• Future and Present Values of Multiple Cash Flows
• Valuing Level Cash Flows: Annuities and
Perpetuities
• Comparing Rates: The Effect of Compounding
Periods
• Loan Types and Loan Amortisation

5-2
Multiple Cash Flows – FV Example 5.1
• Find the value at year 3 of each cash flow
and add them together.
– Today (year 0): FV = 7000(1.08)3 = $8,817.98
– Year 1: FV = 4,000(1.08)2 = $4,665.60
– Year 2: FV = 4,000(1.08) = $4,320
– Year 3: value = $4,000
– Total value in 3 years = 8817.98 + 4665.60 + 4320 + 4000
= $21,803.58
• Value at year 4 = 21,803.58(1.08) = $23,547.87

5-3
Multiple Cash Flows – FV Example 2
• Suppose you invest $500 in a investment fund
today and $600 in one year. If the fund pays 9%
annually, how much will you have in two years?
– FV = 500(1.09)2 + 600(1.09) = $1248.05

5-4
 Example 2 Continued
• How much will you have in 5 years if you make no
further deposits?
• First way:
– FV = 500(1.09)5 + 600(1.09)4 = $1616.26
• Second way – use value at year 2:
– FV = 1248.05(1.09)3 = $1616.26

5-5
Multiple Cash Flows – FV Example 3
• Suppose you plan to deposit $100 into an account
in one year and $300 into the account in three
years. How much will be in the account in five
years if the interest rate is 8%?
– FV = 100(1.08)4 + 300(1.08)2 = 136.05 + 349.92 =
$485.97

5-6
 Example 3 Timeline

0 1 2 3 4 5

100 300

136.05

349.92

$485.97

5-7
Multiple Cash Flows – Present Value
Example 5.3
• Find the PV of each cash flow and add them
– Year 1 CF: 200 / (1.12)1 = 178.57
– Year 2 CF: 400 / (1.12)2 = 318.88
– Year 3 CF: 600 / (1.12)3 = 427.07
– Year 4 CF: 800 / (1.12)4 = 508.41
– Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93

5-8
 Example 5.3 Timeline
0 1 2 3 4

200 400 600 800

318.88

427.07

508.41
$1432.93

5-9
 Multiple Cash Flows – PV Another
Example
• You are considering an investment that will pay you
$1000 in one year, $2000 in two years and $3000
in three years. If you want to earn 10% on your
money, how much would you be willing to pay?
– PV = 1000 / (1.1)1 = $909.09
– PV = 2000 / (1.1)2 = $1652.89
– PV = 3000 / (1.1)3 = $2253.94
– PV = 909.09 + 1652.89 + 2253.94 = $4815.93

5-10
 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?
– Use the CF keys to compute the value of the investment
 CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1
 NPV; I = 15; CPT NPV = $91.49
– No – the broker is charging more than you would be
willing to pay

5-11
 Saving for Retirement
• You are offered the opportunity to put some money
away for retirement. You will receive five annual
payments of $25,000 each beginning in 40 years.
How much would you be willing to invest today if
you desire an interest rate of 12%?
– Use cash flow keys:
 CF; CF0 = 0; C01 = 0; F01 = 39; C02 = 25000; F02 = 5;
NPV; I = 12; CPT NPV = $1084.71

5-12
 Saving for Retirement Timeline

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)

5-13
 Quick Quiz: Part 1
• Suppose you are looking at the following possible
cash flows: Year 1 CF = $100; Years 2 and 3 CFs =
$200; Years 4 and 5 CFs = $300. The required
discount rate is 7%
• What is the value of the cash flows at year 5?
• What is the value of the cash flows today?
• What is the value of the cash flows at year 3?

5-14
 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

5-15
 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 

5-16
 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

5-17
 Annuity – Example 5.5
• 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 
 

5-18
 Annuity – Sweepstakes Example
• Suppose you win the Publishers Clearinghouse
$10 million sweepstakes. The money is paid in
equal annual instalments of $333,333.33 over 30
years. If the appropriate 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

5-19
 Quick Quiz: Part 2
• You know the payment amount for a loan and you
want to know how much was borrowed. Do you
compute a present value or a future value?
• You want to receive $5000 per month in retirement.
If you can earn .75% per month and you expect to
need the income for 25 years, how much do you
need to have in your account at retirement?

5-20
 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?
– 20,000 = C[1 – 1 / 1.006666748] / .0066667
– C = $488.26

5-21
 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%

5-22
 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

5-23
 Quick Quiz: Part 3
• You want to receive $5000 per month for the next 5 years.
How much would you need to deposit today if you can earn
.75% per month?
• What monthly rate would you need to earn if you only have
$200,000 to deposit?
• Suppose you have $200,000 to deposit and can earn .75%
per month
– How many months could you receive the $5000 payment?
– How much could you receive every month for 5 years?

5-24
 Future Values for Annuities
• Suppose you begin saving for your retirement by
depositing $2000 per year in a superannuation
fund. If the interest rate is 7.5%, how much will you
have in 40 years?
– FV = 2000(1.07540 – 1)/.075 = $454,513.04

5-25
 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?
– FV = 10,000[(1.083 – 1) / .08](1.08) = $35,061.12

5-26
 Annuity Due Timeline
0 1 2 3

$10,000 $10,000 $10,000

$32,464

$35,061.12

5-27
 Perpetuity – Example 5.7
• Perpetuity formula: PV = C/r
• Current required return:
– 40 = 1/r
– r = .025 or 2.5% per quarter
• Dividend for new preferred:
– 100 = C/.025
– C = $2.50 per quarter

5-28
Table 5.2

5-29
 Quick Quiz: Part 4
• You want to have $1 million to use for retirement in 35 years.
If you can earn 1% per month, how much do you need to
deposit on a monthly basis if the first payment is made in one
month?
• What if the first payment is made today?
• You are considering preference shares that pay a quarterly
dividend of $1.50. If your desired return is 3% per quarter,
how much would you be willing to pay?

5-30