Chapter 4

Discounted Cash Flow Valuation

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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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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
called the Future Value (FV).
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4.1 The One-Period Case
 If you were to invest $10,000 at 10-percent interest
for one year,

$.... would be interest

$.... is the principal repayment
$.... is the total due.)
 How much is the Future Value (FV) of this
investment?

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4.1 The One-Period Case
 If you were to invest $10,000 at 10-percent interest
for one year,

$ 1,000 would be interest

$ 10,000 is the principal repayment
$ 11,000 is the total due.)
 How much is the Future Value (FV) of this
investment? 11,000

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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.

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Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s 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 called the Present Value (PV).

Note that $10,000 = $9,523.81×(1.05).

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Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 10-percent, how much would
your investment be worth in today’s dollars?

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Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 10-percent, how much would
your investment be worth in today’s dollars?

the Present Value (PV) of the promised $10,000 is $9,090.91

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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.

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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?

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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.
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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

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4.2 The Multiperiod Case
 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.

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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

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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.

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Future Value and Compounding

0 1 2 3 4 5 4-18
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 $20,000

0 1 2 3 4 5

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4.5 Finding the Number of Periods
If we deposit $5,000 today in an account paying 10%,
how long does it take to grow to $10,000?

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What Rate Is Enough?
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 child’s education? About 21.15%.

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Calculator 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

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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?

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Multiple Cash Flows
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
Present Value < Cost → Do Not Purchase 4-24
Valuing “Lumpy” Cash Flows
First, set your calculator to 1 payment per year.
Then, use the cash flow menu:
CF0 0 CF3 600 I 12

CF1 200 F3 1 NPV 1,432.93

F1 1 CF4 800

CF2 400 F4 1

F2 1 4-25
4.3 Compounding Periods
Compounding an investment m times a year for
T years provides for future value of wealth:

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Compounding Periods
 For example, if you invest $50 for 1 years at
12% compounded semi-annually, your
investment will grow to

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Compounding Periods
 For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to

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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:

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Effective Annual Rates of Interest

So, investing at 12.36% compounded annually

is the same as investing at 12% compounded
semi-annually.
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 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 rate of 1½
%.
 This is equivalent to a loan with an annual interest rate of
19.56%.

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EAR on a Financial Calculator

Texas Instruments BAII Plus

keys: description:
[2nd] [ICONV] Opens interest rate conversion menu
[↑] [C/Y=] 12 [ENTER] Sets 12 payments per year
[↓][NOM=] 18 [ENTER] Sets 18 APR.
[↓] [EFF=] [CPT] 19.56

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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:
FV = C0×erT
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 transcendental number approximately equal
to 2.718. ex is a key on your calculator.
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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
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Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

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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.
£15 £15 £15
…
0 1 2 3

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Growing Perpetuity
A growing stream of cash flows that lasts forever
C C×(1+g) C ×(1+g)2
…
0 1 2 3

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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) $1.30 ×(1.05)2
…
0 1 2 3

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Annuity
A constant stream of cash flows with a fixed maturity
C C C C

0 1 2 3 T

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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

0 1 2 3 36

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 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

0 1 2 3 4 5

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Growing Annuity
A growing stream of cash flows with a fixed maturity
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T

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Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000 per
year for 40 years and increase the annual payment by 3% each
year. What is the present value at retirement if the discount rate
is 10%?

$20,000 $20,000×(1.03) $20,000×(1.03)39

0 1 2 40

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Growing Annuity: Example
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%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?

0 1 2 3 4 5
$34,706.26
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4.5 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.

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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?
 PV = 10,000 / 1.07 = 9,345.79

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Interest-Only Loan
 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.

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 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

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 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

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4.6 What Is a Firm Worth?
 Conceptually, a firm should be worth the present value of the
firm’s cash flows.
 The tricky part is determining the size, timing, and risk of
those cash flows.

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 How is the future value of a single cash flow computed?- multiplying the amount
of cash by a function of the expected rate of return over the expected time period
 How is the present value of a series of cash flows computed.- equal to the sum of
the present value of each cash flow
 What is the Net Present Value of an investment? - the sum of all future cash
flows over the investment's lifetime, discounted to the present value
 What is an EAR, and how is it computed? - The Effective Annual Interest Rate
(EAR) is the interest rate that is adjusted for compounding over a given period
 What is a perpetuity? An annuity? A perpetuity is a type of annuity that is set up
so that the payments will never end/ An annuity fund is the investment
portfolio in which an annuity holder's funds are invested. The annuity fund
earns returns, which correlate to the payout that ...

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