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Chapter 4

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23006022
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Chapter 4.

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Chapter 4: Discounted Cash Flow Valuation

1. Valuation: The One‐Period Case

 Present Value of Investment:

- Net Present Value of Investment:

2. The Multiperiod Case

1. FUTURE VALUE AND COMPOUNDING


 The process of leaving the money in the financial market and lending it for
another year is called compounding.
 compound interest: “Money makes money and the money that money makes
makes more money,”
 Future Value of an Investment:

2. PRESENT VALUE AND DISCOUNTING


 How much would an investor need to lend today so that she could receive $1 two
years from today?

3. Compounding Periods

 compounding an investment m times a year provides end-of-year wealth of:


 where is the initial investment and r is the annual percentage rate
(APR)
 Effective annual rate:

3. COMPOUNDING OVER MANY YEARS


 an investment over one or more (t) years, the formula becomes this:

4. CONTINUOUS COMPOUNDING
 continuous compounding: compound every infinitesimal instant
 With continuous compounding, the value at the end of t years is expressed as:

 Where is the initial investment, r is the APR, and t is the number of


years over which the investment runs
 Present Value of an Investment:

4. Simplifications

1. PERPETUITY
 A perpetuity is a constant stream of cash flows without end.

2. GROWING PERPETUITY
 If one assumes that the rise of an investment will continue indefinitely, the cash

flow stream is termed a growing perpetuity.

 important points concerning the growing perpetuity formula:


1. The numerator: The numerator is the cash flow in one period, not at Year
0.
2. The discount rate and the growth rate: The discount rate r must be greater
than the growth rate g for the growing perpetuity formula to work.
3. The timing assumption: Cash generally flows into and out of real-world
firms both randomly and nearly continuously.
 We can apply the growing perpetuity formula ( ) only by
assuming a regular and discrete pattern of cash flow.

3. ANNUITY
 An annuity is a level stream of regular payments that lasts for a fixed number of
periods.

- Present Value at Year 0:

4. GROWING ANNUITY
 a finite number of growing cash flows
5. Loan Amortization

 An amortized loan 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.
 With an equal principal loan, the borrower pays the interest each period plus an
equal principal amount.
 most common way of amortizing a loan is an equal payment loan: the borrower
makes a single, fixed payment every period.

6. What Is a Firm Worth?

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