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Chapter 5

1. An annuity is a series of constant cash flows that occur at regular intervals over a fixed period of time. The present and future value of an annuity can be calculated using annuity formulas. 2. An annuity due is when cash flows occur at the beginning of each period rather than the end. Its value is calculated as an ordinary annuity and then multiplied by 1 + interest rate. 3. A perpetuity is when cash flows continue indefinitely into the future. Its present value is simply the cash flow amount divided by the interest rate.

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488 views3 pages

Chapter 5

1. An annuity is a series of constant cash flows that occur at regular intervals over a fixed period of time. The present and future value of an annuity can be calculated using annuity formulas. 2. An annuity due is when cash flows occur at the beginning of each period rather than the end. Its value is calculated as an ordinary annuity and then multiplied by 1 + interest rate. 3. A perpetuity is when cash flows continue indefinitely into the future. Its present value is simply the cash flow amount divided by the interest rate.

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Jayesh Desai
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Chapter 5: Discounted Cash Flow Valuation

1. Annuity: is a series of constant or level cash flows that occur at the end of each period
for some fixed number of periods is called an ordinary annuity. The cash flows are said
to be in ordinary annuity form.
Annuity Present Value = C x (1 – Present Value Factor)
( r )
= C x {1 – [1/(1+r)t]}
{ r }
The term in parentheses on the first line is sometimes called the present value interest
factor for annuities and abbreviated PVIFA( r , t ).

Annuity Future Value = C x (Future Value Factor - 1)


r
= C x [(1 + r)t - 1]
r
Excel Formulae
 FV(Rate,Nper,Pmt,PV,0/1)
 PV(Rate,Nper,Pmt,FV,0/1)
 RATE(Nper,Pmt,PV,FV,0/1)
 NPER(Rate,Pmt,PV,FV,0/1)
 PMT(Rate,Nper,PV,FV,0/1)
Ordinary annuity = 0 (default; no entry needed)
Annuity Due = 1 (must be entered)

2. Annuity Due: is an annuity for which the cash flows occur at the beginning of each
period. Almost any type of arrangement in which we have to prepay the same amount
each period is an annuity due.
Annuity Due Value = Ordinary Annuity Value x (1 + r)

Calculate the present or future value as though it were an ordinary annuity, and
multiply your answer by (1 + r )
3. Perpetuity: When the level stream of cash flows continues forever. Such an asset is
called a perpetuity because the cash flows are perpetual. Perpetuities are also called
consols in Canada and the United Kingdom.
PV for a perpetuity = C
r

Formulae at a Glance
a. Symbols:
PV = Present value, what future cash flows are worth today
FVt = Future value, what cash flows are worth in the future
r = Interest rate, rate of return, or discount rate per period
t = Number of periods.
C = Cash amount

b. Future Value of C per Period for t Periods at r Percent per Period:


FVt = C x {[(1 + r)t - 1]/r}
A series of identical cash flows is called an annuity, and the term [(1 + r)t - 1]/r is
called the annuity future value factor.

c. Present Value of C per Period for t Periods at r Percent per Period:


PV = C x {1 - [1/(1 + r)t ]}/r
The term {1 - [1/(1 + r)t ]}/r is called the annuity present value factor.

d. Present Value of a Perpetuity of C per Period:


PV = C/r
A perpetuity has the same cash flow every year forever.

4. Growing Annuity Present Value = C x { [1 – (1 + g)]t }


{[ (1 + r) ] }
{ r–g }

Growing perpetuity present value = C x [1/(r – g)]

5. Effective Annual Rate (EAR): Which is actually the rate one will earn per annum.
EAR = [1 + (Quoted rate/m)]m – 1
m = the number of times the interest is compounded during the year.

6. Pure Discount Loan: is the simplest form of loan in which, the borrower receives
money today and repays a single lump sum at some time in the future.

7. Interest Only Loans: The repayment plan calls for the borrower to pay interest each
period and to repay the entire principal (the original loan amount) at some point in the
future

8. Amortized Loan: The lender may require the borrower to repay parts of the loan
amount over time. The process of providing for a loan to be paid off by making regular
principal reductions is called amortizing the loan.

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