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Chapter 6: Discounted Cash Flows and Valuation
Learning Objectives
1. Explain why cash flows occurring at different times
must be adjusted to reflect their value as of a
common date before they can be compared, and
compute the present value and future value for
multiple cash flows.
2. Describe how to calculate the present value and
the future value of an ordinary annuity and how
an ordinary annuity differs from an annuity due.
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Learning Objectives
3. Explain what a perpetuity is and where we see
them in business and calculate the value of a
perpetuity.
4. Discuss growing annuities and perpetuities, as well
as their application in business, and calculate their
values.
5. Discuss why the effectIVE annual interest rate
(Ear) is the appropriate way to annualize interests
rates, and calculate the ear.
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Multiple Cash Flows
future value of multiple cash flows
1. Draw a timeline to determine the number of periods for
which each cash flow will earn the rate-of-return
2. Calculate the future value of each cash flow using
Equation 5.1
3. Add the future values
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Future Value of Two Cash Flows
………………………….
………………………….
………………………….
………………………….
………………………….
……………….
Exhibit 6.1 Future Value of Two Cash Flows
This exhibit shows a timeline for two cash flows invested in a
savings account that pays 10 percent interest annually. The
total amount in the savings account after two years is
$2,310, which is the sum of the future values of the two cash
flows.
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Future Value of Three Cash Flows
………………………….
………………………….
………………………….
……………….
Exhibit 6.2 Future Value of Three Cash Flows
The exhibit shows a timeline for an investment program
with a three-year horizon. The value of the investment at
the end of three years is $3,641, the sum of the future
values of the three separate cash flows.
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Present Value of Three Cash Flows
….….
….….
….….
….….
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Level Cash Flows: Annuities and Perpetuities
Annuity
A series of equally-spaced and level cash flows extending
over a finite number of periods
Perpetuity
A series of equally-spaced and level cash flows that
continue forever
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Level Cash Flows: Annuities and Perpetuities
Ordinary Annuity
cash flows occur at the end of a period
mortgage payment
interest payment to bondholder
Exhibits 6.1, 6.2, and 6.3
Annuity Due
cash flows occur at the beginning of a period
lease
Exhibit 6.7
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Level Cash Flows: Annuities and Perpetuities
Calculate present value of an annuity
PVA = CF ´ PVFA
0
é1 - PVFA ù
= CF ´ ê úû
ë i
é 1 ù
ê1 - (1 + i ) n
ú
= CF ´ ê ú (6.1)
ê i ú
êë úû
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Level Cash Flows: Annuities and Perpetuities
calculate present value of an annuity
To calculate a future value or a present value is to
calculate an equivalent amount
The amount reflects an adjustment to account for the
effect of compounding
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Level Cash Flows: Annuities and Perpetuities
calculate present value of an annuity
Present value of an annuity
amount needed produce the annuity
current fair value or market price of the annuity
amount of a loan that can be repaid with the annuity
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Level Cash Flows: Annuities and Perpetuities
Present Value of an Annuity Example
A contract will pay $2,000 at the end of each year for
three years and the appropriate discount rate is 8%.
What is a fair price for the contract?
é(1 - 1/(1 + 0.08) ù
3
PVA = $2000 ´ ê
3
ú = $5,154.19
ë 0.08 û
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Level Cash Flows: Annuities and Perpetuities
Calculator Example
Present Value of Annuity
Enter 3 8 2,000 0
N i PV PMT FV
Answer -5,154.19
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Level Cash Flows: Annuities and Perpetuities
Calculate an Annuity Example
You borrow $400,000 to buy a home. The 30-year
mortgage requires 360 monthly payments at a monthly
rate of 6.15%/12 or .51042%. How much is the monthly
payment?
……….………………………….
é(1 - 1/(1 + 0.0051042) ù 360
$400,000 = Pmt ´ ê úû
ë ……….………………………….
0.0051042
$400,000 / 164.5784 = Pmt
…….………………….….
$2,430.45 = Pmt
….……….
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Present Value Annuity Factors
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Level Cash Flows: Annuities and Perpetuities
Loan Amortization
How borrowed funds are repaid over the life of a loan
Each payment includes less interest and more principal;
the loan is paid off with the last payment
Amortization schedule shows interest and principal in
each payment, and amount of principal still owed after
each payment
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Amortization Table for a 5-Yr, $10,000 Loan at
5% Interest
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Using Excel – Loan Amortization Table
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Using Excel – Calculating the Interest Rate for
an Annuity
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Level Cash Flows: Annuities and Perpetuities
Finding the Interest Rate
The present value of an annuity equation can be used to
find the interest rate or discount rate for an annuity
To determine the rate-of-return for an annuity, solve the
equation for i
Using a calculator is easier than a trial-and-error
approach
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Level Cash Flows: Annuities and Perpetuities
Calculator Example
Finding the Interest Rate
An insurer requires $350,000 to provide a guaranteed annuity
of $50,000 per year for 10 years. What is the rate-of-return for
the annuity?
Enter 10 -350,000 50,000 0
N i PV PMT FV
Answer 7.073
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