6

Formulas

1
Discounted Cash Flow Valuation
2 Key Concepts and Skills

 Be able to compute the future value of

multiple cash flows
 Be able to compute the present value
of multiple cash flows
 Be able to compute loan payments
 Be able to find the interest rate on a
loan
 Understand how interest rates are
quoted
 Understand how loans are amortized or
paid off
3 Chapter Outline

 Future and Present Values of Multiple Cash Flows

 Valuing Level Cash Flows: Annuities and Perpetuities
 Comparing Rates: The Effect of Compounding
 Loan Types and Loan Amortization
Multiple Cash Flows
4

Two ways to calculate FV of multiple CFs:

1. Compound the accumulated balance forward one

period at a time

2. Calculate the FV of each CF separately and add

them up.
5 FV Example

 Consider the future value of $2,000 invested at the

end of each of the next five years. The rate is 10%.
6
FIGURE 6.2
7
FIGURE 6.3
8
FIGURE 6.4
9 Multiple Cash Flows – FV
Example
 Suppose you invest $500 in a mutual fund today
and $600 in one year. If the fund pays 9% annually,
how much will you have in two years?
 FV = 500(1.09)2 + 600(1.09) = 1248.05
 Multiple Cash Flows – Example
Continued
10

 How much will you have in 5 years if you make no

further deposits?
 First way:
 FV = 500(1.09)5 + 600(1.09)4 = 1616.26
 Second way – use value at year 2:
 FV = 1248.05(1.09)3 = 1616.26
11 Multiple Cash Flows – FV
Example 2
 Suppose you plan to deposit $100 into an account in
one year and $300 into the account in three years.
How much will be in the account in five years if the
interest rate is 8%?
 FV = 100(1.08)4 + 300(1.08)2 = 136.05 + 349.92 =
485.97
12 PV Calculations

 Suppose we had an investment that was going to

pay $1,000 at the end of every year for the next five
years. The discount rate is 6%. What is the PV?
13
FIGURE 6.5
14
FIGURE 6.6
 Multiple Cash Flows – Present
Value Example
15

 You are offered an investment that will pay

you $200 in one year, $400 the next year, $600
the next year, and $800 at the end of the
fourth year. You can earn 12% on very similar
investments. What is the most you should pay
for this one today?
16 Example 6.3 Timeline
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
17 Example Answer

 Find the PV of each cash flows and add them

 Year 1 CF: 200 / (1.12)1 = 178.57
 Year 2 CF: 400 / (1.12)2 = 318.88
 Year 3 CF: 600 / (1.12)3 = 427.07
 Year 4 CF: 800 / (1.12)4 = 508.41
 Total PV = 178.57 + 318.88 + 427.07 + 508.41 =
1432.93
 Multiple Cash Flows – PV Another
Example
18

 You are considering an investment that will pay you

$1000 in one year, $2000 in two years and $3000 in
three years. If you want to earn 10% on your
money, how much would you be willing to pay
today?
 PV = 1000 / (1.1)1 = 909.09
 PV = 2000 / (1.1)2 = 1652.89
 PV = 3000 / (1.1)3 = 2253.94
 PV = 909.09 + 1652.89 + 2253.94 = 4815.93
19 Multiple Cash Flows Using a
Spreadsheet
 You can use the PV or FV functions in Excel to find
the present value or future value of a set of cash
flows
 Setting the data up is half the battle – if it is set up
properly, then you can just copy the formulas
 Click on the Excel icon for an example
20 Quick Quiz – Part I

 Suppose you are looking at

the following possible cash
flows: Year 1 CF = $100; Years
2 and 3 CFs = $200; Years 4
and 5 CFs = $300. The
required discount rate is 7%
 What is the value of the cash
flows at year 5?
 What is the value of the cash
flows today?
21 Annuities and Perpetuities
Defined
 Annuity – finite series of equal payments that occur
at regular intervals
 If the first payment occurs at the end of the period, it is
called an ordinary annuity
 If the first payment occurs at the beginning of the
period, it is called an annuity due
 Perpetuity – infinite series of equal payments
Annuities and Perpetuities – Basic
22
Formulas
 Perpetuity: PV = C / r
 Annuities:

 1 
 1  
(1  r ) t
PV C  
 r 
 
 (1  r ) t  1 
FV C  
 r 
23
24 Annuity – Example

 After carefully going over your budget, you have

determined you can afford to pay $632 per month
towards a new sports car. You call up your local
bank and find out that the going rate is 1% per
month for 48 months. How much can you borrow
today?

 1 
 1 
(1.01) 48 
PV 632  23,999.54
 .01 
 
25 Annuity – Sweepstakes
Example
 Suppose you win the Publishers Clearinghouse $10
million sweepstakes. The money is paid in equal
annual installments of $333,333.33 over 30 years.
If the appropriate discount rate is 5%, how much is
the sweepstakes actually worth today?
 PV = 333,333.33[1 – 1/1.0530] / .05 = 5,124,150.29
26 Annuities on the
Spreadsheet - Example
 The present value and future value formulas in a
spreadsheet include a place for annuity payments
 Click on the Excel icon to see an example
27 Finding the Payment

 Suppose you want to borrow $20,000 for a new car.

You can borrow at 8% per year, compounded
monthly (8/12 = .66667% per month). If you take a
4 year loan, what is your monthly payment?
 20,000 = C[1 – 1 / 1.006666748] / .0066667
 C = 488.26
28 Finding the Payment on a
Spreadsheet
 Another TVM formula that can be found in a
spreadsheet is the payment formula
 PMT(rate,nper,pv,fv)
 The same sign convention holds as for the PV and FV
formulas
 Click on the Excel icon for an example
 Finding the Number of Payments
– Example
29

 You ran a little short on your spring break

vacation, so you put $1000 on your credit card.
You can only afford to make the minimum
payment of $20 per month. The interest rate
on the credit card is 1.5 percent per month.
How long will you need to pay off the $1,000.
 Start with the equation and remember your
logs.
 1000 = 20(1 – 1/1.015t) / .015
 .75 = 1 – 1 / 1.015t
 1 / 1.015t = .25
 1 / .25 = 1.015t
 t = ln(1/.25) / ln(1.015) = 93.111 months = 7.75
years
30 Finding the Rate

 A relative of yours wants to borrow $3,000. she

offers to repay you $1,000 every year for four years.
What interest rate are you being offered?
 Annuity – Finding the Rate Without
a
31

Financial Calculator
 Trial and Error Process
 Choose an interest rate and compute the
PV of the payments based on this rate
 Compare the computed PV with the
actual loan amount
 If the computed PV > loan amount, then
the interest rate is too low
 If the computed PV < loan amount, then
the interest rate is too high
 Adjust the rate and repeat the process
until the computed PV and the loan
amount are equal
32 Quick Quiz – Part III

 You want to receive $5000 per month

for the next 5 years. How much
would you need to deposit today if
you can earn .75% per month?
 Suppose you have $200,000 to
deposit and can earn .75% per
month.
 How many months could you receive the $5000 payment?
 How much could you receive every month for 5 years?
33 Future Values for Annuities

 Suppose you begin saving for your retirement by

depositing $2000 per year in a bank. If the interest
rate is 7.5%, how much will you have in 40 years?
 FV = 2000(1.07540 – 1)/.075 = 454,513.04
34 Annuity Due

 You are saving for a new house and you put $10,000
per year in an account paying 8%. The first
payment is made today. How much will you have at
the end of 3 years?
 FV = 10,000[(1.083 – 1) / .08](1.08) = 35,061.12
35 Annuity Due Timeline
0 1 2 3

10000 10000 10000

32,464

35,016.12
36 Perpetuity – Example 6.7

 Perpetuity formula: PV = C / r

 Why is called perpetuity?

37 Example

You are considering preferred

stock that pays a quarterly
dividend of $1.50. If your desired
return is 3% per quarter, how
much would you be willing to
pay?
38 Table 6.2
39 Effective Annual Rate (EAR)

 This is the actual rate paid (or

received) after accounting for
compounding that occurs during
the year
 If you want to compare two
alternative investments with
different compounding periods
you need to compute the EAR
and use that for comparison.
40 Annual Percentage Rate

 This is the annual rate that is quoted by law

 By definition APR = period rate times the number of
periods per year
 What is the APR if the monthly rate is .5%?
 .5(12) = 6%
 What is the APR if the semiannual rate is .5%?
 .5(2) = 1%
41 Things to Remember

 You ALWAYS need to make sure that the

interest rate and the time period match.
 If you are looking at annual periods, you
need an annual rate.
 If you are looking at monthly periods,
you need a monthly rate.
 If you have an APR based on monthly
compounding, you have to use monthly
periods for lump sums, or adjust the
interest rate appropriately if you have
payments other than monthly
42 Computing EARs - Example

 Suppose you can earn 1% per month

on $1 invested today.
 What is the APR? 1(12) = 12%
 How much are you effectively earning?
 FV = 1(1.01)12 = 1.1268
 Rate = (1.1268 – 1) / 1 = .1268 = 12.68%
 Suppose if you put it in another
account, you earn 3% per quarter.
 What is the APR? 3(4) = 12%
 How much are you effectively earning?
 FV = 1(1.03)4 = 1.1255
 Rate = (1.1255 – 1) / 1 = .1255 = 12.55%
43 Computing APRs from EARs

 If you have an effective rate, how can you compute

the APR? Rearrange the EAR equation and you get:


APR m (1  EAR)
1
m
-1
 
44 APR - Example

 Suppose you want to earn an

effective rate of 12% and you are
looking at an account that
compounds on a monthly basis.
What APR must they pay?
 1 / 12
APR 12 (1  .12) 
 1 .113 8655152
or 11.39%
45 Decisions, Decisions II

 You are looking at two savings accounts.

One pays 5.25%, with daily compounding.
The other pays 5.3% with semiannual
compounding. Which account should you
use?
 First account:
 EAR = (1 + .0525/365)365 – 1 = 5.39%
 Second account:
 EAR = (1 + .053/2)2 – 1 = 5.37%
 Which account should you choose and
why?
46 Decisions, Decisions II
Continued
 Let’s verify the choice. Suppose you invest $100 in
each account. How much will you have in each
account in one year?
 First Account:
 Daily rate = .0525 / 365 = .00014383562
 FV = 100(1.00014383562)365 = 105.39

 Second Account:
 Semiannual rate = .053 / 2 = .0265
 FV = 100(1.0265)2 = 105.37

 You have more money in the first account.

47 Computing APRs from EARs

 If you have an effective rate, how can you compute

the APR? Rearrange the EAR equation and you get:


APR m (1  EAR)
1
m
-1
 
48 APR - Example

 Suppose you want to earn an effective rate of 12%

and you are looking at an account that compounds
on a monthly basis. What APR must they pay?


APR 12 (1  .12) 1 / 12

 1 .113 8655152
or 11.39%
 Future Values with Monthly
Compounding
49

 Suppose you deposit $50 a month into an account

that has an APR of 9%, based on monthly
compounding. How much will you have in the
account in 35 years?
 Monthly rate = .09 / 12 = .0075
 Number of months = 35(12) = 420
 FV = 50[1.0075420 – 1] / .0075 = 147,089.22
50 Present Value with Daily
Compounding
 You need $15,000 in 3 years for a new car. If you
can deposit money into an account that pays an
APR of 5.5% based on daily compounding, how
much would you need to deposit?
 Daily rate = .055 / 365 = .00015068493
 Number of days = 3(365) = 1095
 PV = 15,000 / (1.00015068493)1095 = 12,718.56
51 Continuous Compounding

 The general formula for the future

value of an investment
compounded continuously over
many periods can be written as:
FV = C × erT
Where
C is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately equal to 2.718.
ex is a key on your calculator.
52 Quick Quiz – Part V

 What is the definition of an APR?

 What is the effective annual rate?
 Which rate should you use to compare alternative
investments or loans?
 Which rate do you need to use in the time value of
money calculations?
53 Pure Discount Loans –
Example
 Treasury bills are excellent examples of pure
discount loans. The principal amount is repaid at
some future date, without any periodic interest
payments.
 If a T-bill promises to repay $10,000 in 12 months
and the market interest rate is 7 percent, how much
will the bill sell for in the market?
 PV = 10,000 / 1.07 = 9345.79
54 Interest Only Loan -
Example
 Consider a 5-year, interest only loan with a 7%
interest rate. The principal amount is $10,000.
Interest is paid annually.
 What would the stream of cash flows be?
 Years 1 – 4: Interest payments of .07(10,000) = 700
 Year 5: Interest + principal = 10,700

 This cash flow stream is similar to the cash flows on

corporate bonds and we will talk about them in
greater detail later.
Amortized Loan with Fixed Principal
55
Payment - Example
 Consider a $50,000, 10 year loan at 8%
interest. The loan agreement requires the
firm to pay $5,000 in principal each year
plus interest for that year.
 Click on the Excel icon to see the
amortization table
Amortized Loan with Fixed Payment -
56
Example
 Each payment covers the interest expense plus
reduces principal
 Consider a 4 year loan with annual payments. The
interest rate is 8% and the principal amount is
$5,000.
 What is the annual payment?
 4N
 8 I/Y
 5,000 PV
 CPT PMT = -1,509.60

 Click on the Excel icon to see the amortization table

57 Work the Web Example
 There are web sites available that can easily
prepare amortization tables
 Click on the web surfer to check out the
Bankrate.com site and work the following
example
 You have a loan of $25,000 and will repay the
loan over 5 years at 8% interest.
 What is your loan payment?
 What does the amortization schedule look like?
58 Quick Quiz – Part VI
 What is a pure discount loan? What is a
good example of a pure discount loan?
 What is an interest-only loan? What is a
good example of an interest-only loan?
 What is an amortized loan? What is a
good example of an amortized loan?
 6
Formulas

59
End of Chapter
60 Comprehensive Problem
 An investment will provide you with $100 at the
end of each year for the next 10 years. What is
the present value of that annuity if the discount
rate is 8% annually?
 What is the present value of the above if the
payments are received at the beginning of each
year?
 If you deposit those payments into an account
earning 8%, what will the future value be in 10
years?
 What will the future value be if you opening the
account with $1,000 today, and then make the
$100 deposits at the end of each year?