Week 4

D I S C O U N T E D C A S H F L O W V A L U AT I O N

McGraw-Hill/Irwin Copyright © 2013 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 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 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.

4-7
 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

4-10
 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 . 1 0  (1 . 4 0 ) 5

$ 1 . 1 0  (1 . 4 0 ) 4
$ 1 . 1 0  (1 . 4 0 ) 3
$ 1 . 1 0  (1 . 4 0 ) 2
$ 1 . 1 0  (1 . 4 0 )

$ 1 .1 0 $ 1 .5 4 $ 2 .1 6 $ 3 .0 2 $ 4 .2 3 $ 5 .9 2

0 1 2 3 4 5 4-14
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  5
(1 . 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
4-16
 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
4-18
 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 4-19
 4.3 COMPOUNDING PERIODS

Compounding an investment m times a year for T

years provides for future value of wealth:

m T
 r 
FV  C 0   1  
 m

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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:

2 3
 . 12 
F V  $ 50   1    $ 50  (1 . 06 ) 6  $ 70 . 93
 2 

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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 4-22
 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 ) 2
(1  r ) 3

C
PV 
r
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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

£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 4-25
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 ) 2
(1  r ) 3
(1  r ) T

C  1 
PV  1  (1  r ) T 
r   4-27
 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 )  4-28
 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 )  
 4-29
 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   4-30
 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 $9,095 $ 9 , 7 3 1 . 6 5 $ 1 0 , 4 1 2 . 8 7 $ 1 1 ,1 4 1 . 7 7

0 1 2 3 4 5
$34,706.26
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 4.5 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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