Chapter 4

Discounted Cash Flow Valuation

Questions
⚫ How is the future value of a single cash flow
computed?
⚫ How is the present value of a series of cash
flows computed.
⚫ What is the Net Present Value of an
investment?
⚫ What is an EAR, and how is it computed?
⚫ What is a perpetuity? An annuity?

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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
call the Future Value (FV).
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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.

$10,000
$9,523.81 =
1.05
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

⚫ In the one-period case, the formula for PV

can be written as:
C1
PV =
1+ r

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
$10,000
NPV = −$9,500 +
1.05
NPV = −$9,500 + $9,523.81
NPV = $23.81

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

4-8
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

$1.10  (1.40) 5

$1.10  (1.40) 4
$1.10  (1.40)3
$1.10  (1.40) 2
$1.10  (1.40)

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5 4-12
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
$20,000
$9,943.53 =
(1.15)5
4-13
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?
FV = C0  (1 + r ) T
$10,000 = $5,000  (1.10) T

$10,000
(1.10) = T
=2
$5,000
ln( 1.10)T = ln( 2)

ln( 2) 0.6931
T= = = 7.27 years
ln( 1.10) 0.0953
4-14
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%.
FV = C0  (1 + r ) T
$50,000 = $5,000  (1 + r )
12

$50,000
(1 + r ) =
12
= 10 (1 + r ) = 101 12
$5,000

r = 10
1 12
− 1 = 1.2115 − 1 = .2115
4-15
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?

4-16
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
4-17
4.3 Compounding Periods
Compounding an investment m times a year
for T years provides for future value of wealth:
mT
 r
FV = C0  1 + 
 m

4-18
Compounding Periods
❑ For example, if you invest $50 for 3 years
at 12% compounded semi-annually, your
investment will grow to

23
 .12 
FV = $50  1 +  = $50  (1.06) = $70.93
6

 2 

4-19
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?”
.12 23
FV = $50  (1 + ) = $50  (1.06) = $70.93
6

2
The Effective Annual Rate (EAR) of interest is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
$50  (1 + EAR)3 = $70.93
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Effective Annual Rates of Interest
FV = $50  (1 + EAR)3 = $70.93
$70.93
(1 + EAR) =
3

$50
13
 $70.93 
EAR =   − 1 = .1236
 $50 
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%.
m 12
 r  .18 
 1 +  =  1 +  = (1.015)12
= 1.1956
 m  12 
4-22
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.
4-23
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
4-24
Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3

C
PV =
r
4-25
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

15
PV = = 150
.10
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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
C C  (1 + g ) C  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r−g 4-27
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

$1.30
PV = = $26.00
.10 − .05
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Annuity
A constant stream of cash flows with a fixed maturity
C C C C

0 1 2 3 T

C C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) T

C 1 
PV = 1 − T 
r  (1 + r )  4-29
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

$400  1 
PV = 1− 36 
= $12,954.59
.07 / 12  (1 + .07 12)  4-30
 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%?
4
$100 $100 $100 $100 $100
PV1 =  t
= 1
+ 2
+ 3
+ 4
= $323.97
t =1 (1.09) (1.09) (1.09) (1.09) (1.09)

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
$327 .97
PV = = $297 .22
0 1.09 4-31
2-31
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
C C  (1 + g ) C  (1 + g )T −1
PV = + ++
(1 + r ) (1 + r ) 2
(1 + r )T
C   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
  4-32
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

$20,000   1.03  
40

PV = 1 −    = $265,121.57
.10 − .03   1.10   4-33
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%?
$8,500  (1.07) 2 = $8,500  (1.07) 4 =
$8,500  (1.07) = $8,500  (1.07)3 =
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

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

4-35
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

4-36
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.

4-37
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

4-38
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

4-39
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.

4-40
Exercise 1
⚫ Given r as the rate of return, T as the holding
period, find rT that roughly makes the profit of
investment double.

⚫ 2X=X(1+r)T
⚫ 2=(1+r) T =>ln2=0.693=T * ln(1+r) ≒rT
⚫ It is closed to 72 rule (rT=72 makes
investment profit dounle)

4-41