Lecture 2 & 3

Topics Covered

• Future Values and Present Values.

• Looking for Shortcuts—Perpetuities and Annuities.
• More Shortcuts—Growing Perpetuities and Annuities.
• How Interest Is Paid and Quoted.

2
Present Value and Future Value

• Future Value.
• Amount to which an investment will grow after earning interest.

• Compound Interest.
• Interest earned on wealth that grows at a compound rate.

• Present Value.
• Value today of a future cash flow.

3
Future Values

• The Future Value refers to the estimated value of a sum of money

at a specified point in the future, considering a predetermined
interest rate or investment return.
• Helps individuals and businesses make informed decisions about
investments, savings, and financial planning.
• Calculating the future value aids in understanding how the
purchasing power of money may change over time due to
inflation or investment growth.
• Future Value of $100 = F V

4
Future Values

• Example: FV
• What is the future value of $100 if interest is compounded
annually at a rate of 7% for 2 years?

5
Future Values With Compounding

6
Present Value

• Discount factor = DF = PV of $1

• Discount factors can be used to compute the present value of any

cash flow.

7
Present Value

• Present Value is the current worth of a sum of money that is

expected to be received or paid in the future. It involves
discounting future cash flows back to their equivalent value in
today's terms.

• Present value = P V

8
Present Value

• The PV formula has many applications. Given any variables in the

equation, you can solve for the remaining variable. Also, you can
reverse the prior example.

9
Present Values With Compounding

• Access the text alternative for these images

10
Valuing an Investment Opportunity

• Step 1: Forecast cash flows.

• Step 2: Estimate opportunity cost of capital.

• If equally risky investments in the capital market offer a return of
7%, then

• Cost of capital = r = 7%

11
Valuing an Investment Opportunity

• Step 3: Discount future cash flows.

• Step 4: Go ahead if PV of payoff exceeds investment.

12
Net Present Value

• Net Present Value (NPV) is a financial metric used to evaluate

the profitability of an investment or project.
• NPV calculates the difference between the present value of
expected cash inflows (such as revenues, receipts, or savings)
and the present value of expected cash outflows such as costs,
expenses, or investments) over the life of an investment or
project.

13
NPV Calculation

14
Risk and Present Value

15
Risk and Net Present Value

16
Net Present Value Rule

• Accept investments that have positive net present value.

• Example
• Use the original example. Should we accept the project given a
10% expected return?

17
Rate of Return Rule

• Accept investments that offer rates of return in excess of their

opportunity cost of capital.

• Example
• In the project listed below, the foregone investment opportunity
is 12%. Should we do the project?

18
Calculating Present Values With Multiple
Cash Flows

• For multiple periods we have the discounted cash flow (DCF)

formula.

19
NPV Calculation

20
How to Value Perpetuities

• Sometimes there are shortcuts that make it very easy to calculate

the present value of an asset that pays off in different periods.
• These tools allow us to cut through the calculations quickly.

• A perpetuity is a security that pays for an infinite amount of time.

In finance, perpetuity is a constant stream of identical cash flows
with no end.

• A perpetuity is a constant stream of cash flows without end.

• British bonds called consols.

21
Shortcuts

• Perpetuity: Financial concept in which a cash flow is theoretically

received forever.

22
Shortcuts

• Perpetuity: Financial concept in which an evenly spaced level

cash flow is theoretically received forever.

• Note: Each cash flow is received at the end of the period.

23
Present Values

• Example
• What is the present value of $1 billion every year, for all eternity,
if you estimate the perpetual discount rate to be 10%?

24
Present Values

• Example
• What if the investment does not start making money for 3 years
(first payment received at the end of the third year)?

25
How to Value Annuities

• Annuity: An asset that pays a fixed sum each year for a specified
number of years.

26
Perpetuities and Annuities

• PV Annuity Factor (PVAF): The present value of $1 a year for

each of t years.

27
Annuity (and its relationship to perpetuities)

28
Costing an Installment Plan

29
Paying off a Bank Loan

30
Amortizing Loan Example

Beginning-of-Year Year-End Interest on Total Year-End Amortization of End-of-Year

Year Balance Balance Payment Loan Balance
1 $1,000.00 $100.00 $315.47 $215.47 $784.53

2 784.53 78.45 315.47 237.02 547.51

3 547.51 54.75 315.47 260.72 286.79

4 286.79 28.68 315.47 286.79 0

31
Future Value of an Annuity

• Example: Suppose you invest $429.59 annually at the beginning

of each year at 10% interest. After 50 years, how much would
your investment be worth?

32
Future Value of an Annuity

• Future Value of an Annuity: The future value of an asset that

pays a fixed sum each year for a specified number of years.

33
Future Value of an Annuity

• Example
• What is the future value of $20,000 paid at the end of each of the
following 5 years, assuming your investment returns 8% per
year?

34
Valuing Annuities Due

• Annuity due: Level stream of cash flows starting immediately.

• How does it differ from an ordinary annuity?

• How does the future value differ from an ordinary annuity?

35
Growing Perpetuities

• Present value of growing perpetuity

• g = the annual growth rate of the cash flow

36
Growth Perpetuity Example

• Example
• What is the present value of $1 billion paid at the end of every
year in perpetuity, assuming a rate of return of 10% and a
constant growth rate of 4%?

37
How Interest Is Paid and Quoted

• Annual Percentage Rate: Interest rate that is annualized using

simple interest.
• Effective Annual Interest Rate: Interest rate that is annualized
using compound interest.

38
EAR and APR Formulas

• Annual Percentage Rate (APR):

• Effective Annual Interest Rate (EAR):

EAR = (1+r/m)m - 1

39
Effective Interest Rates

• Example:
• Given a monthly rate of 1%, what is the annual percentage rate
(APR)? What is the effective annual rate (EAR)?

40