DISCOUNTED CASH FLOWS Chapter 06

CHAPTER-06

DISCOUNTED CASH FLOWS

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 DISCOUNTED CASH FLOWS Chapter 06

Annuities:
An annuity is a series of regular periodic payments of equal amount, for example Rs. 30000
each year for year 1 to 5. Rs. 500 each month for months 1 to 24.
Types of Annuities:
Ordinary Annuity:
Payments are in arrears or at the end of the time period.
Annuity Due:
Payment is in advance or in the beginning of each payment period.
Deferred/Delayed Annuity:
First Payment is to be made after some delay time period.

Future Value of Annuities:

Ordinary Annuity:
(𝟏+𝐫)𝐧 −𝟏 If examiner is
𝐒 = 𝐑( )
𝐫 silent then by
𝐫 𝐧𝐦
default
(𝟏+ ) −𝟏
𝐦
𝐒 = 𝐑( 𝐫 )
𝐦

Annuity Due:
(𝟏+𝐫)𝐧 −𝟏
𝐒 = 𝐑( ) (𝟏 + 𝐫)
𝐫

𝐫 𝐧𝐦
(𝟏+ ) −𝟏 𝐫
𝐦
𝐒 = 𝐑( 𝐫 ) (𝟏 + 𝐦)
𝐦

Example 1: A saving scheme involves investing Rs. 100,000 p.a for 4 years. If rate of interest is 10% p.a.
What is the sum to be received at the end of 4 years?
(464100)
Example 2: Find the future value of an annuity of Rs. 500 for 7 years at interest rate of 14%
compounded annually.
(5365.24)
Example 3: Hamza Invests Rs. 10,000 every year starting from today for next 10 years. If rate of
interest is 10% p.a. Find future value of the annuity.
(175311.67)
Example 4: Rs. 200 is invested at the end of each month in an account paying interest of 6% p.a
compounded monthly. What is the future value of this annuity after 10th payment?

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 DISCOUNTED CASH FLOWS Chapter 06

Present Value of Annuity:

Ordinary:
𝟏−(𝟏+𝐫)−𝐧
𝐏 = 𝐑( )
𝐫

𝐫 −𝐧𝐦
𝟏−(𝟏+ )
𝐦
𝐏 = 𝐑( 𝐫 )
𝐦

Annuity Due:
𝟏−(𝟏+𝐫)−𝐧
𝐏 = 𝐑( ) (𝟏 + 𝐫)
𝐫

𝐫 −𝐧𝐦
𝟏−(𝟏+ ) 𝐫
𝐦
𝐏 = 𝐑( 𝐫 ) (𝟏 + 𝐦)
𝐦

Example 1: Rs. 10,000 is paid every year to pay off a loan. What is the loan amount if interest rate is
14% compounded annually?
(343308)
Example 2: Find present value of an annuity of Rs. 3000 for 15 years at 4.5% compounded annually.
(32218.63)

Example 3: What is the present value of Rs. 15000 received at the end of the current year and next
four years? If rate of interest is 7%.
(61502.96)
Example 4: Tipu Sultan borrows Rs. 500,000 to buy a house. If he pays equal installments for 20 years
and 10% interest on outstanding balance, what will be equal annual installment?
(R=58729.81)

Practice Now.

Question 1: Mr. Shakeel bought a T.V costing Rs. 30,000 by making a down payment of Rs. 3000 and
agreeing to make equal annual payments for four years. How much would be each payment
if interest on unpaid amount is 14% compounded annually.
(R=9266.50)
Question 2: How much amount is required to invest every year so as to accumulate Rs. 30,000 at the
end of 10 years? Rate of interest is 10% compounded annually.
(R = 1882.36)
Question 3: Rs. 680,000 loan calls for payment to be made in 10 annual installments. If interest is 14%
compounded annually, find annual payment that must be made. (Using PV, R=130365.20)

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 DISCOUNTED CASH FLOWS Chapter 06

Question 4: A firm has set up a Contingency fund yielding 16% interest per year compounded
quarterly. The firm will be able to deposit Rs. 10,000 into the fund at the end of each
quarter. Find value of the fund at the end of three years.
(S=150258.05)

Question 5: Ahmad Purchased a new car a made a down payment of Rs. 50,000. He is further required
to pay Rs. 30,000 at the end of each quarter for 5 five years. Find the cash purchase price of
the car if quarterly payments include 12% interest compounded quarterly.
(Cash price= Down payment +PV= 496324.25)
Question 6: A man agrees to pay 4500 per month for 30 months to pay off a loan. If interest rate of
18% p.a is charged monthly. Find amount of loan taken.
(PV=108071.27)
Question 7: Zain has purchased a motorcycle with Rs. 40,000 from his friend, who has given him the
following options at 10% costs of funds compounded annually.
i) Pay 52000 at the end of 4 years
ii) Pay 12000 annually for the next 4 years.
iii) Pay 16000 annually for the next 3 years.
iv) Purchase on Net Cash
Which option Zain should prefer?
(Option (i) should prefer as its PV is less than that of others)

Mr. Ali plans to borrow Rs. 400,000 to buy a new car. The loan will be for 3
Challenge!
years at 12% annual rate compounded monthly. He can pay Rs. 12500 per
month during the first year. What monthly amount would he be required to
pay during the next two years in order to repay the loan amount?

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 DISCOUNTED CASH FLOWS Chapter 06

Sol. (Case 1) Amount paid in year 1 by Ali

r nm
(1+ ) −1
m
S = R( r ) (S=158531.28)
m

(Case 2) What amount to pay in year 1?

𝑟 𝑛𝑚
𝑆 = 𝑃 (1 + 𝑚) (S=450730.012)
Remaining amount to be paid after 1 year time period:
450730.012- 158531.28 = 292198.71
(Case 3), Required monthly installment for last two years’ time period.

r −nm
1−(1+ )
m
P = R( r ) (R=13754.80)
m

Deferred or Delayed Annuity:

First payment is delayed for a specific time period.

Ordinary:
1−(1+r)−n
P = R( ) (1 + r)−d
r
d Delay period in years
r −nm
1−(1+ )
m r −dm
P = R( r ) (1 + m)
m
Annuity Due:
1−(1+r)−n
P = R( ) (1 + r)(1 + r)−d
r

r −nm
1−(1+ )
m r r −dm
P = R( r ) (1 + m) (1 + m)
m

Example 1: Mr. Babar deposited a certain amount of money today and is supposed to receive 30
annual payments 5000 each. However the annuity will start after 4 years from today and rate
of interest is 5% compounded annually. Calculate amount of money deposited.
(d=4, P=63234)
Example 2: Mr. Malik borrows from bank Rs. 12, 00,000 at the rate of 9% p.a. to be repaid in six equal
installments with interest, the first installment falling due at the end of 4th year. Find the
amount of each installment.
Sol. P=1200, 000, R=? n=6, d=3, r=0.09
1−(1+r)−n
` P = R( ) (1 + r)−d (R= 346425.10)
r

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 DISCOUNTED CASH FLOWS Chapter 06

Perpetuities:
• Perpetuity in the financial system is a situation where a stream of cash flow payments
continues indefinitely or is an annuity that has no end.
• No future value
• Un-define time period.
𝐑
• 𝐏= 𝐫

𝐑 Annuity
• 𝐏= 𝐫
𝐦 Due

𝐑
• 𝐏 = 𝐫 (𝟏 + 𝒓)

Example 1: Mr. Smith is expected to pay Rs. 18 every year on share of its stock, what is the present
value of this share if money is worth 9% compounded annually.
(200)
Example 2: A firm wants to establish a library fund for a university. The firm would provide Rs. 25000
every six months. Fund yield a 10% annual rate of interest compounded semi-annually. What
is the initial deposit required to establish a stream of payments from the interest every six
months after making the first payment from the principal.
25000
Sol. (25000 + 0.1 ) = 525000
2

Example 3: How much is needed to ensure a monthly pension of Rs. 60,000 at the beginning of each
month indefinitely, if the money is worth 9% compounded monthly?
𝐑
Sol. 𝐏 = (𝟏 + 𝒓) (Rs. 80, 60,000)
𝐫

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 DISCOUNTED CASH FLOWS Chapter 06

Net Present Value (NPV):

• Net present value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time
• It is a return required by the investor
• Project accepted if NPV is positive
• Project rejected if NPV is negative.

Example 1: A Company with a cost of capital of 10% is considering investing in a project with the
following cash flow.
Years Rs.(millions)

0 (10,000)

1 6000
2 8000

Should project be undertaken?

Sol.
NPV = 8000(1 + 0.1)−2 + 6000(1 + 0.1)−1 − 10000 = 𝟐𝟎𝟔𝟔
(Accepted)
Example 2: A Company is considering whether to invest in a project in a project costing Rs. 53000.
Project would have a four years life and estimated cash profits over the four years are given.
Calculate NPV using discount rate of 11%

Years 0 1 2 3 4
Cash Flow (53000) 17000 25000 16000 12000
(2210)

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 DISCOUNTED CASH FLOWS Chapter 06

Example 3: Calculate NPV at 12%

Years 0 1-4 5-8 9 - 10

Cash Flow (300,000) 50,000 40,000 30,000
Sol.

1 − (1 + 0.12)−2 1 − (1 + 0.12)−4
NPV = 30000 ( ) (1 + 0.12)−8 + 40000 ( ) (1 + 0.12)−4
0.12 0.12
1 − (1 + 0.12)−4
+ 50000 ( ) − 300,000
0.12
Negative(50443.5 approx.)
Example 3(A): A Company is considering whether to invest in a project which would involve in
purchase of machinery with a life of 5 years. Machine would cost Rs. 556,000 and would
have a net disposal value of Rs. 56000 at the end of year 5. Project would earn annual cash
flow of Rs. 200,000. Find NPV at 15%.
1−(1+0.15)−5
Sol. NPV = 56000(1 + 0.15)−5 + 200000 ( ) − 556000 = 𝟏𝟒𝟐𝟐𝟕𝟐
0.15
Example 4: A construction Company is considering a project costing Rs. 1700,000 now plus Rs. 800,000
at the end of year 1. Net earnings will be Rs. 500,000 per annum from year 2 to year 8. The
Company required a return of 11% per annum. Find NPV.
1−(1+0.11)−7
Sol. NPV = 500000 ( ) (1 + 0.11)−1 − 800000(1 + 0.11)−1 − 1700000 = −𝟐𝟗𝟖𝟏𝟎𝟗
0.11

Challenge! A Project requires Rs. 800,000 to be invested today. In return it will yield
two inflows of certain amount at the end of the first and second year
respectively in such a way that the first amount is twice that of the second
amount. If cost of capital and NPV is 10% and 1200,000 respectively,
compute the amount to be received at the end of second year.

Sol. Let 1st inflow = 2x

2nd inflow = x
NPV = 1200,000
So, 1200,000 = 2x(1 + 0.1)−1 + x(1 + 0.1)−2 − 800000
x = 756250
𝟎
(756250 to be received at the end of the second year)

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 DISCOUNTED CASH FLOWS Chapter 06

Internal Rate of Return (IRR):

• The internal rate of return (IRR) is the annual rate of growth that an investment is
expected to generate. IRR is calculated using the same concept as net present value
(NPV), except it sets the NPV equal to zero.
• If IRR ≥ expected rate then project will be accepted
• If IRR < expected rate then project will be rejected

Example 1: Find IRR of the given data

Years 0 1 2 3 4
Cash Flow (213000) 65200 96000 73100 55400
Sol.
NPV = 0 at IRR (14.04%)

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 DISCOUNTED CASH FLOWS Chapter 06

Example 2: Find rate at which NPV of both companies will same

Years 1 2 3
Company A 900 ---- 800
Company B 200 1000 600
(18.81%)
Formula:
𝐍𝐏𝐕𝐀
𝐈𝐑𝐑 = 𝐀% + ( ) (𝐁 − 𝐀)%
𝐍𝐏𝐕𝐀 − 𝐍𝐏𝐕𝐁

• 𝑁𝑃𝑉𝐴 Positive
• 𝑁𝑃𝑉𝐵 Negative
• A < Expected rate
• B > Expected rate
• Higher rate for Negative NPV
• Lower rate for Positive NPV

Example 1: A business requires a minimum expected rate of return of 12% on its investment having
following cash flows.
Years 0 1 2 3 4
C.F (80,000) 20,000 36,000 30,000 17,000
Find IRR.
Sol.
A = 10% B= 15%
NPVA = 2084 NPVB = (5942)
So, IRR = 11.3% (11.3%)
Alt.
17000(1 + x)−4 + 30000(1 + x)−3 + 36000(1 + x)−2 + 20000(1 + x)−1 − 80000 = 0

(11.23%)

Practice Now

Question 1: The following information is about a project. Project has an NPV of 2210 at a discount rate
of 11%. Estimate IRR of the project.
0 1 2 3 4
(53000) 17000 25000 16000 12000

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Sol. A = 11% B= 15%

NPVA = 2210 NPVB = (1932)
So, IRR = 13.13% (13.13%)
Alt.
12000(1 + x)−4 + 16000(1 + x)−3 + 25000(1 + x)−2 + 17000(1 + x)−1 − 53000 = 0

(13.1%)

Question 2: The following Information is about a project. The project has an NPV of (1515) at a
discount rate of 8%. Estimate IRR of the Project.

0 1 2 3
(65000) 27000 31000 15000
(6.6%)

Try it!

Solution Desk Private Limited intends to invest Rs 4 million into a project which would yield
12,14 and 16 percent during three years respectively. The company would also recover the
original investment after 3 years. Company’s cost of capital is 10%, Find NPV of the Project
(Rs. 385274.2)

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