Principles of

Corporate Chapter 3
Finance
How To Calculate Present
Seventh Edition
Values
Richard A. Brealey
Stewart C. Myers

Slides by
Matthew Will

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 3- 2

Topics Covered
 Valuing Long-Lived Assets
 PV Calculation Short Cuts
 Compound Interest
 Nominal and Real Rates of Interest (inflation)
 Example: Present Values and Bonds

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Present Values

Discount Factor = DF = PV of $1

DF  1
(1r ) t

 Discount Factors can be used to compute

the present value of any cash flow.

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Present Values

C1
PV  DF C1 
1  r1

DF  (11r ) t
 Discount Factors can be used to compute
the present value of any cash flow.

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Present Values

Ct
PV  DF C t  t
(1  r )

 Replacing “1” with “t” allows the formula to

be used for cash flows that exist at any point
in time
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Present Values

Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on
your money, how much money should you set aside today
in order to make the payment when due in two years?

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Present Values

Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on
your money, how much money should you set aside today
in order to make the payment when due in two years?

PV  3000
(1.08 ) 2
$2,572.02

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Present Values

 PVs can be added together to evaluate

multiple cash flows.

C1 C2
PV  (1r )1  (1r ) 2 ....

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Present Values
 Given two dollars, one received a year from now
and the other two years from now, the value of each
is commonly called the Discount Factor. Assume r 1
= 20% and r2 = 7%.

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Present Values
 Given two dollars, one received a year from now
and the other two years from now, the value of each
is commonly called the Discount Factor. Assume r 1
= 20% and r2 = 7%.

DF1  1.00
(1.20 )1
.83
DF2  1.00
(1.07 ) 2
.87
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Present Values

Example
Assume that the cash flows
from the construction and sale
of an office building is as
follows. Given a 7% required
rate of return, create a present
value worksheet and show the
net present value.

Year 0 Year 1 Year 2

 150,000  100,000  300,000

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Present Values

Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 7% required rate of return, create a
present value worksheet and show the net present value.

Discount Cash Present

Period
Factor Flow Value
0 1. 0  150,000  150,000
1 1
1.07 .935  100,000  93,500
2 1
1.07 2
.873  300,000  261,900
NPV Total  $18,400
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Short Cuts

 Sometimes there are shortcuts that make it

very easy to calculate the present value of an
asset that pays off in different periods. These
tolls allow us to cut through the calculations
quickly.

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Short Cuts

Perpetuity - Financial concept in which a cash

flow is theoretically received forever.

cash flow
Return 
present value
C
r
PV
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Short Cuts

Perpetuity - Financial concept in which a cash

flow is theoretically received forever.

cash flow
PV of Cash Flow 
discount rate
C1
PV 
r

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Short Cuts

Annuity - An asset that pays a fixed sum each

year for a specified number of years.

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Short Cuts

Annuity - An asset that pays a fixed sum each

year for a specified number of years.

1 1 
PV of annuity C   t
 r r 1  r  

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Annuity Short Cut

Example
You agree to lease a car for 4 years at $300 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of capital
is 0.5% per month, what is the cost of the lease?

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Annuity Short Cut

Example - continued
You agree to lease a car for 4 years at $300 per month.
You are not required to pay any money up front or at
the end of your agreement. If your opportunity cost of
capital is 0.5% per month, what is the cost of the lease?

 1 1 
Lease Cost 300   48 
 .005 .0051  .005 
Cost $12,774.10

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Compound Interest
i ii iii iv v
Periods Interest Value Annually
per per APR after
compounded
year period (i x ii) one year interest rate

1 6% 6% 1.06 6.000%

2 3 6 1.032 = 1.0609 6.090

4 1.5 6 1.0154 = 1.06136 6.136

12 .5 6 1.00512 = 1.06168 6.168

52 .1154 6 1.00115452 = 1.06180 6.180

365 .0164 6 1.000164365 = 1.06183 6.183

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Compound Interest

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Compound Interest

18
16 10% Simple
14
12 10% Compound
FV of $1

10
8
6
4
2
0

Number of Years

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Compound Interest

Example
Suppose you are offered an automobile loan at an APR of
6% per year. What does that mean, and what is the true
rate of interest, given monthly payments?

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Compound Interest
Example - continued
Suppose you are offered an automobile
loan at an APR of 6% per year. What
does that mean, and what is the true rate
of interest, given monthly payments?
Assume $10,000 loan amount.

12
Loan Pmt 10,000 (1.005)
10,616.78
APR 6.1678%
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Inflation

Inflation - Rate at which prices as a whole are

increasing.

Nominal Interest Rate - Rate at which money

invested grows.

Real Interest Rate - Rate at which the

purchasing power of an investment increases.

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Inflation

1+nominal interest rate

1  real interest rate = 1+inflation rate

approximation formula

Real int. rate nominal int. rate - inflation rate

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Inflation
Example
If the interest rate on one year govt. bonds is 5.9%
and the inflation rate is 3.3%, what is the real
interest rate?
1+.059
1 + real interest rate = 1+.033 Savings

1 + real interest rate = 1.025 Bond

real interest rate = .025 or 2.5%

Approximation =.059-.033 =.026 or 2.6%

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Valuing a Bond
Example
If today is October 2002, what is the value of the following bond?
 An IBM Bond pays $115 every Sept for 5 years. In Sept 2007 it pays
an additional $1000 and retires the bond.
 The bond is rated AAA (WSJ AAA YTM is 7.5%)

Cash Flows
Sept 0102 03 04 05
115 115 115 115 1115

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Valuing a Bond

Example continued
If today is October 2002, what is the value of the following bond?
 An IBM Bond pays $115 every Sept for 5 years. In Sept 2007 it pays an
additional $1000 and retires the bond.
 The bond is rated AAA (WSJ AAA YTM is 7.5%)

115 115 115 115 1,115

PV     
1.075 1.075 1.075 1.075 1.0755
2 3 4

$1,161.84

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Bond Prices and Yields

1600

1400

1200
Price

1000

800

600

400

200

0
0 2 4 6 8 10 12 14 Yield
5 Year 9% Bond 1 Year 9% Bond
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