Corporate Finance

Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan

Chapter 4:
Discounted Cash Flow Valuation
Dr. Le Anh Tuan
 Key Concepts and Skills
• Be able to compute the future value and/or
present value of a single cash flow or series of
cash flows.
• Be able to compute the return on an investment.
• Be able to use a financial calculator and/or
spreadsheet to solve time value problems.
• Understand perpetuities and annuities.

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 Chapter Outline
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 Loan Amortization
4.6 What Is a Firm Worth?

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 Future Value
The general formula for the future value of an investment
over many periods can be written as:

"# = $# ! (! + % )
!

Where
PV is present value,
r is interest rate
t or n is the number of periods over which the cash is invested.

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 Discount rate
• Also called rate of return, hurdle rate, cost of capital,
opportunity cost of capita. It incorporates all of the three
reasons for present valuing cash flows:
• Opportunity costs: Be offered more in the future to give
up present consumption.
• Expected Inflation: a dollar tomorrow would be worth
less than a dollar today
• Risk: Uncertainty in the future reduces the value of the
cash flow.

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 Present Value
!!
In the one-period case: "# =
!+ $
Where C1 is cash flow at Date 1, and r is the appropriate
interest rate. PV is the current value of future cash flows
discounted at the appropriate discount rate.
In the multiple-period case (discounted cash flow DCF
formula):

1
k-year discount factor.
(1 + 𝑟)!

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 Net Present Value
The formula for NPV can be written as:

NPV = −Cost + PV

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 Example 1
You’ve just earned a $2,000 scholarship. You’d like to
eventually take a summer trip that costs $2,800 this month
and is expected to increase by 2% monthly. You deposit your
scholarship in a bank with an interest rate of 5% per month.
Will you be able to afford the trip with your scholarship in 5
months later?

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 Example 2
The insurance company is estimating operating costs. They
estimate that 1700 customers will retire in exactly 8 years and
that each will be due an insurance benefit of $1,000 at that
time. The company has a safe investment account where
they can earn 4% per year. How much do they need to put
into this account now to be able to pay those expenses?

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 Type of Cash Flows
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.

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 Perpetuity
• A constant stream of cash flows that lasts forever.
• For example: Console bonds in the UK; Stock valuation

! ! !
"# = + + + !!!
(# + $ ) (# + $ ) (# + $ )
! "

!
"# =
$

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 Perpetuity: Example
What is the value of a British consol that promises to pay £15
every year for ever?
The interest rate is 10 percent.

!"#
!" = = !"#$
%"$

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 Growing Perpetuity
A growing stream of cash flows that lasts forever

! ! (# + " ) ! ! (# + " )
!
!
#$ = + + +!
(# + % ) (# + % ) !
(# + % )
"

!
"# =
$!%
Access the text alternative for slide images.
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 Growing Perpetuity: Example
The expected dividend next year is $1.30, and dividends are
expected to grow at 5 percent forever.
If the discount rate is 10 percent, what is the value of this
promised dividend stream?

!"#$%
!" = = !&'#%%
#"% ! #%(

Access the text alternative for slide images.

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 Example
A firm paid a dividend of $3 per share recently. Investors
expect that the annual dividend will rise by g = 6% forever.
The appropriate discount rate r = 11%. What is the fair price
of the stock today?

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 Growing Perpetuity
Three cautions in using the formula for PV of growing perpetuity
1. Numerator: In the formula, the numerator is the cash flow one
period hence, not at date 0
2. Discount rate and growth rate: r must greater than g
3. Time assumption
In practice, cash flows occurs randomly and continuously. But in
the formula, cash flows are assumed to be received regularly at
discrete time points.

Access the text alternative for slide images.

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 Growing Perpetuity
A more general equation:

!
! ! ! #$ + " % ! ! #$ + " % ! #$ + # % !
" $% = + + +! = =
#$ + # % #$ + # % !
#$ + # % "
#$ + " % ##"
$#
#$ + # %

Access the text alternative for slide images.

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 Annuity
A constant stream of cash flows with a fixed maturity
• Ordinary Annuity: cash flows at the end of each period
• Annuity Due: cash flows at the beginning of each period

Ordinary Annuity
" " " "
#$ = + + +!
( ) (# + % ) (# + % )
# + % ! "
(# + % )
!

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 Annuity: Example I
If you can afford a $400 monthly car payment, how much can you
afford if interest rates are 7 percent on 36-month loans?

! "
# $
#$%% # & $ = #&'()*$+*)
!" = &%
+%, # & +%, ' $ !"

&' #, (*& + &' )+ $-

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 Annuity: Example II
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 percent?
!
%"&& %"&& %"&& %"&& %"&&
"#" = ! !
= "
+ #
+ $
+ !
= %$#$'()
! =" "'&( "'&( "'&( "'&( "'&(

Access the text alternative for slide images.

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 Annuity: Example III (Annuity due)
Mark Young received $50,000 a year for 20 years from the state
lottery. Assume that the first payment occurs immediately.
Under this new assumption, we have a 19-year annuity with the
first payment occurring at Year 1-plus an extra payment at Year 0.

Access the text alternative for slide images.

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 Annuity due

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 Growing Annuity
A growing stream of cash flows with a fixed maturity

" " (! + # ) " " (! + # )

! !!
"
$% = + + # ! #$
( ) (! + C )
! + C "
(! + C )
!

" ! # !+ # $ "
!

$% = %! ' ( ) &
C ' # % (* (! + C ) )+ &
, -
Access the text alternative for slide images.
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 Growing Annuity: Example I
A defined-benefit retirement plan offers to pay $20,000 per year for
40 years and increase the annual payment by 3 percent each year.
What is the present value at retirement if the discount rate is 10
percent?

#$"%""" ! # &'"( $ "

!"

!" = && % ( ) ' = #$)*%&$&'*+

'&" % '"( &, * &'&" + '-

Access the text alternative for slide images.

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 Growing Annuity: Example II
You are evaluating an income-generating property. Net rent is
received at the end of each year. The first year’s rent is expected
to be $8,500, and rent is expected to increase 7 percent each
year. What is the present value of the estimated income stream
over the first five years if the discount rate is 12 percent?

Access the text alternative for slide images.

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 Compounding Periods
Compounding an investment m times a year for T years
provides for future value of wealth:

! "∗$
FV = PV(1 + )
"

r is the annual percentage rate (APR)

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 Compounding Periods
For example, if you invest $1,000 for one year at 10
percent interest compounded semiannually, your
investment will grow to:

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 Effective Annual Rates
What is the end-of-year wealth if we receive an APR of 24%
compounded monthly on a $1 investment?

The annual rate of return is 26.82%, and this rate is called the
effective annual rate (EAR) or the effective annual yield (EAY).

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 APR, EAR or EAY
The annual percentage rate (APR) is the quoted annual rate,
or the interest rate charged per period times the number of
periods over which it compounds.

The effective annual rate (EAR), or the annual percentage

yield (APY) is the rate you actually pay or earn based on
the compounding.

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 APR, EAR or EAY
You bank offers to pay you 12% compounded quarterly. What
is the APR? What is the EAR? What is the EAY?

APR = 12%
For the first period: $100 x 1.03 = 103
For the second period: $103 x 1.03 = 106.09
For the third period: $106.09 x 1.03 = 109.2727
For the fourth period: $109.2727 x 1.03 = 112.55088

Thus, the EAR = EAY = 12.55%

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 Continuous Compounding
The general formula for the future value of an investment compounded
continuously over many periods can be written as:

#$ = %! ! C !"

Where
C0 is the initial investment,
r is the APR,
t is the number of years, and
e is a transcendental number approximately equal to 2.718
Continuous compounding assumes that interest is being added to the
principal continuously, without any discrete intervals.

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 4.5 Loan Types
• 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.

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 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?

!" = !"#$### "%#& = !'$()*%&'

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 Interest-Only Loan
Consider a five-year, interest-only loan with a 7 percent
interest rate. The principal amount is $10,000. Interest is paid
annually.
What would the stream of cash flows be?
• Years 1 to 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.

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 Amortized Loan with Fixed Principal
Payment
Consider a $5000, 5 year loan at 9 percent interest. The loan
agreement requires the firm to pay $1,000 in principal each year
plus interest for that year.

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 Amortized Loan with Fixed Payment
The most common type of an amortized loan:
• The borrower makes a single, fixed payment every period
• Consumer loans (such as car loans), mortgages,…
Suppose a 5-year, 9%, $5,000 loan was amortized in this
way
• This loan’s cash flows are in the form of an ordinary annuity
• How to determine C ???
→ The PV of all cash flows = the principal of the loan ($5,000)

$5,000 C C C C C

0 1 2 3 4 5

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 Amortized Loan with Fixed Payment
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! # S $! "
&S % ( ) '
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:!; 888 = + + ! + = !
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& '
, -
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, 8789 -
###################################################AB12P(4+#)%*#(1C,#2(1*a

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 Firm Valuation
On way to determine how much a firm is worth is to
calculate the present value of its future cash flows.
The value of the firm is simply the sum of the present
values of the individual net cash flows.

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 Example
Suppose a firm is expected to generate net cash flows
(cash inflows – cash outflows) of $5,000 in year 1 and
$2,000 in year 2 to year 6. The firm can be sold for
$10,000 7 years from now. The owners can make 10%
on their investment in the firm.
What is the value of this firm?

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 4.6 What Is a Firm Worth?
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Suppose you have the opportunity to acquire this firm for
$12,000 now. Should you acquire this firm?

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 Suggested exercises
Concept Questions
3, 4

Questions and Problems

8, 11, 14, 15, 16, 17, 23, 25, 26, 29,
33, 35, 36, 49, 51, 52

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