4-0
Discounted Cash Flow Valuation
Chapter 4
Copyright © 2013 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
4-1
Be able to compute the future value and/or present value of a single cash flow or series of cash flows
Be able to compute the return on an investment
Be able to use a financial calculator and/or spreadsheet to solve time value problems
Understand perpetuities and annuities
4-2
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 Loan Amortization
4.6 What Is a Firm Worth?
4-3
If you were to invest $10,000 at 5-percent interest for one year, your investment would grow to $10,500.
$500 would be interest ($10,000 × .05)
$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:
$10,500 = $10,000×(1.05)
The total amount due at the end of the investment is called the Future Value (FV).
4-4
In the one-period case, the formula for FV can be written as:
FV = C0×(1 + r)
Where C0 is cash flow today (time zero), and
r is the appropriate interest rate.
Interest rate – “exchange rate” between earlier money and later money
4-5
If you were to be promised $10,000 due in one year when interest rates are 5-percent, your investment would be worth $9,523.81 in today’s dollars.
05.1
000,10$81.523,9$
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is called the Present Value (PV).
Note that $10,000 = $9,523.81×(1.05),
i.e., FV = PV (1+r)
4-6
In the one-period case, the formula for PV can be written as:
r
CPV
1
1
Where C1 is cash flow at date 1, and
r is the appropriate interest rate,
i.e., PV = FV / (1+r)
4-7
How much is the FV of $1 invested at 10 percent for one year?
FV = $1 x (1.1) = $1.10
How much do we need to invest today at 10 percent to get $1 in one year?
PV = ?
Need to solve PV x (1+ r) =$1,
i.e., PV x (1.1) = $1,
i.e., PV = $1/(1+r) = $1/(1.1) = $.909
Suppose you need $105 in one year. If you can earn 5% annually, how much do you need to invest today?
PV = $105/(1.05) = $100
4-8
The Net Present Value (NPV) of an investment is the present value of the expected cash flows, less the cost of the investment.
Suppose an investment that promises to pay $10,000 in one year is offered for sale for $9,500. Your interest rate is 5%. Should you buy?
4-9
81.23$
81.523,9$500,9$
05.1
000,10$500,9$
NPV
NPV
NPV
The present value of the cash inflow is greater
than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.
4-10
In the one-period case, the formula for NPV can be written as:
NPV = –Cost + PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :
$9,500×(1.05) = $9,975 < $10,000
4-11
The general formula for the future value of an investment over many periods can be written as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is invested.
4-12
Suppose a stock currently pays a dividend of $1.10, which is expected to grow at 40% per year for the next five years.
What will the dividend be in five years?
FV = C0×(1 + r)T
$5.92 = $1.10×(1.40)5
4-13
Notice that the dividend in year five, $5.92, is considerably higher than the sum of the original dividend plus five increases of 40-percent on the original $1.10 dividend:
$5.92 > $1.10 + 5×[$1.10×.40] = $3.30
This is due to compounding.
4-140 1 2 3 4 5
10.1$
3)40.1(10.1$
02.3$
)40.1(10.1$
54.1$
2)40.1(10.1$
16.2$
5)40.1(10.1$
92.5$
4)40.1(10.1$
23.4$
4-15
4-16
4-17
Suppose you invest the $1,000 at 5% for 5 years.
How much would you have?
FV = $1000 x (1.05)5 = $1276.28
Value with simple interest=(.05)x1,000x5=$250, so future value with simple interest = $1,250
The effect of compounding is small for a small
number of periods, but increases as the number of
periods increases.
The effect of compounding also increases with the
interest rate.
4-18
Suppose you had a relative deposit $10 at 5.5%
interest 200 years ago. How much would the
investment be worth today?
FV = $10 x (1.055)200 = $447,189.84
What is the effect of compounding?
Simple interest = (.055)x$10x200 = $110, so future value with simple interest = $120
Compounding added $447,069.84 to the value of the investment!
4-19
Suppose your company expects to increase unit
sales of widgets by 15% per year for the next 5
years. If you currently sell 3 million widgets in one
year, how many widgets do you expect to sell
during the fifth year?
FV = 3,000,000(1.15)5 = 6,034,072
4-20
How much do I have to invest today to have some amount in the future?
Discounting: The process of going from future values (FVs) to Present Values (PVs)
When we talk about discounting, we mean finding the present value of some future amount.
When we talk about the “value” of something, we are talking about the present value unless we specifically indicate that we want the future value.
4-21
General Formula: FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t
Example: Suppose you need $115.76 in three years.
If you can earn 5% annually, how much do you need
to invest today?
PV = $115.76/(1.05)3 = 115.76/1.1576 = $100
4-22
How much would an investor have to set aside today in order to have $20,000 five years from now if the current rate is 15%?
0 1 2 3 4 5
$20,000PV
5)15.1(
000,20$53.943,9$
4-23
Make sure that your calculator can display a large
number of decimals.
- [orange key=2nd][FORMAT]9[ENTER]
Make sure that calculator assumes one payment per
period/per year (this is default)
- Press 1 [2nd] [P/Y]
Make sure it is in end mode (this is default, but can
change to BGN mode w/ [2nd][BGN][ENTER]).
4-24
• Remember to clear the registers (orange key + clr work) before
(and after) each problem
Put a negative sign on cash outflows, positive sign
on cash inflows.
- e.g., a loan:
Payments are negative,
FV is negative (outflows to pay off the loan)
PV is positive (loan inflow)
4-25
Texas Instruments BA-II Plus
FV = future value
PV = present value
I/Y = periodic (annual) interest rate Interest will be compounded for number of periods you enter
in P/Y
Interest is entered as a percent, not a decimal
N = number of periods
Remember to clear the registers (CLR WORK) after each problem
Other calculators are similar in format
4-26
Suppose you need $10,000 in one year for the down
payment on a new car. If you can earn 7% annually, how
much do you need to invest today?
PV = $10,000 / (1.07)1 = $9,345.79
Calculator
1 N
7 I/Y
10,000 FV
CPT PV = -9,345.79
4-27
You want to begin saving for your daughter’s college
education and you estimate that she will need $150,000 in 17
years. If you feel confident that you can earn 8% per year,
how much do you need to invest today?
PV = $150,000 / (1.08)17 = $40,540.34
To use the calculator:
17 N
8 I/Y
150000 FV
CPT PV
4-28
Your parents set up a trust fund for you 10 years ago
that is now worth $19,671.51. If the fund earned 7%
per year, how much did your parents invest?
PV = $19,671.51 / (1.07)10 = $10,000
Calculator
10 N
7 I/Y
19671.51 FV
CPT PV
4-29
Your parents set up a trust fund for you and invest
$20,000 today. How much will the fund be worth in
8 years at 6% per year?
FV = $20,000 (1.06)8 = $31,877
Calculator
8 N
6 I/Y
-20000 PV
CPT FV = 31876.96
4-30
For a given interest rate – the longer the time period,
the lower the present value (ceteris paribus: all else
equal)
What is the present value of $500 to be received
in 5 years? 10 years? The discount rate is 10%
5 years: PV = $500 / (1.1)5 = $310.46
10 years: PV = $500 / (1.1)10 = $192.77
4-31
For a given time period – the higher the interest rate, the
smaller the present value (ceteris paribus)
What is the present value of $500 received in 5 years
if the interest rate is 10%? 15%?
Rate = 10%: PV = $500 / (1.1)5 = $310.46
Rate = 15%; PV = $500 / (1.15)5 = $248.59
4-32
4-33
What is the relationship between present value and future value?
Suppose you need $15,000 in 3 years. If you can earn 6% annually, how much do you need to invest today? PV = 15,000/(1.06)3 = 12,594
If you could invest the money at 8%, would you have to invest more or less than at 6%?
A) More, B) Less, C) The Same, D) Can’t Tell
How much? PV at 8% = 15,000/(1.08)3 = 11,907
So, less by 12594 – 11907 = 687
4-34
Often, we will want to know what the implied interest rate is in an investment
- e.g., you have been offered an investment that doubles your money in 10 years. What is the approximate rate of return on the investment?
Rearrange the basic PV equation and solve for r
FV = PV(1 + r)t
r = (FV / PV)1/t – 1
4-35
You are looking at an investment that will pay
$1,200 in 5 years if you invest $1,000 today. What
is the implied rate of interest?
r = ($1,200 / $1,000)1/5 – 1 = .03714 = 3.714%
Calculator – the sign convention matters!!!
5 N
-1000 PV (you pay $1,000 today)
1200 FV (you receive $1,200 in 5 years)
CPT I/Y = 3.714%
4-36
Suppose you are offered an investment that will
allow you to double your money in 6 years. You
have $10,000 to invest. What is the implied rate of
interest?
r = ($20,000 / $10,000)1/6 – 1 = .122462 = 12.25%
Calculator:
6 N
-10000 PV
20000 FV
CPT I/Y = 12.25%
4-37
I would like to retire in 30 years as a millionaire. If I
have $10,000 today, what rate of return I need to
achieve my goal?
$10,000 = $1,000,000/(1 + r)30
(1+r) 30 = 100
r = 16.59%
Calculator: N =30; FV = 1,000,000;
PV = -10,000; CPT I/Y = 16.59%
4-38
What are some situations in which you might want to compute the implied interest rate?
Suppose you are offered the following investment choices: You can invest $500 today and receive $600 in 5 years.
You can invest the $500 in a bank account paying 4% annually.
What is the implied interest rate for the first choice and which investment should you choose?
r = (600 / 500)1/5 – 1 = 3.714% Calculator: N = 5; PV = -500; FV = 600; CPT I/Y = 3.714%
Note that 4% > 3.714% and the FV of depositing the money in a bank account is $608.326 > 600.
4-39
Start with basic equation and solve for t (remember
your logs)
FV = PV(1 + r)t
(1 + r)t = FV / PV
ln (1 + r)t = ln(FV / PV)
tln (1 + r) = ln(FV / PV)
t = ln(FV / PV) / ln(1 + r)
You can use the financial keys on the calculator as
well.
4-40
Recall formula: t = ln(FV / PV) / ln(1 + r)
You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car?
t = ln($20,000 / $15,000) / ln(1.1) = 3.02 years
Calculator: -15000 PV, 20000 FV, 10 I/Y,
CPT N = 3.02
4-41
Suppose you want to buy a new house. You
currently have $15,000 and you figure you need to
have a 10% down payment plus an additional 5% in
closing costs on the remaining balance. If the type
of house you want costs about $150,000 and you
can earn 7.5% per year, how long will it be before
you have enough money for the down payment and
closing costs?
4-42
How much do you need to have in the future?
Compute the number of periods
Using the formula
4-43
How much do you need to have in the future?
Down payment = .1($150,000) = $15,000
Closing costs = .05($150,000 – 15,000) = $6,750
Total needed = $15,000 + 6,750 = $21,750
Compute the number of periods
PV = -15,000
FV = 21,750
I/Y = 7.5
CPT N = 5.14 years
Using the formula, t = ln(FV/PV)/ln(1+r)
t = ln($21,750 / $15,000) / ln(1.075) = 5.14 years
4-44
If we deposit $5,000 today in an account paying 10%, how long does it take to grow to $10,000?
TrCFV )1(0 T)10.1(000,5$000,10$
2000,5$
000,10$)10.1( T
)2ln()10.1ln( T
years 27.70953.0
6931.0
)10.1ln(
)2ln(T
4-45
When might you want to compute the number of periods?
Suppose you want to buy some new furniture for your family room. You currently have $500 and the furniture you want costs $600. If you can earn 6%, how long will you have to wait if you don’t add any additional money?
t = ln(600/500) / ln(1.06) = 3.13 years Calculator: PV = -500; FV = 600; I/Y = 6; CPT N
= 3.13 years
4-46
Consider an investment that pays $200 one year from now, with cash flows increasing by $200 per year through year 4. If the interest rate is 12%, what is the present value of this stream of cash flows?
If the issuer offers this investment for $1,500, should you purchase it?
4-47
First, set your calculator to 1 payment per year i.e., 2ND P/Y=1.000
Then, use the cash flow menu:
C02
C01
F02
F01
CF0
1
200
1
$-67.068
-1,500
400
I
NPV
12
C04
C03
F04
F03 1
600
1
800
4-48
0 1 2 3 4
200 400 600 800178.57
318.88
427.07
508.41
1,432.93
Present Value < Cost OR NPV < 0 → Do Not Purchase
4-49
Back to first e.g. we did in class (not on ppt’s)
Cost=$1,200 in t=0, Returns: $100 in t=1, $100 in t=2, $400 in t=3, $500 in t=4, $500 in t=5
If r=3% → NPV = $232.952 (hence, there was a rounding up error in my handwritten calculations), invest
If r=10% → NPV = $-73.953, do not invest; the alternative investment at 10% is better
4-50
Compounding periods
Within-year compounding:
To this point, we have assumed annual interest rates; however, many projects / investments have different periods. For example, bonds typically pay interest semi-annually, and house loans are on a monthly payment schedule.
Continuous compounding:
We could compound semiannually, quarterly, monthly, daily, hourly, each minute or at every infinitesimal instant (i.e., continuously)
Effective Annual Rate (EAR)
4-51
Compounding an investment m times a year for Tyears provides for future value of wealth:
By setting T=1, we get the formula for compounding over one year.
r is the stated annual interest rate without consideration of compounding. Annual Percentage Rate (APR) is the most common synonym.
Tm
m
rCFV
10
4-52
For example, if you invest $50 for 3 years at 12% compounded semi-annually, your investment will grow to:
93.70$)06.1(50$2
12.150$ 6
32
FV
4-53
You are considering two savings accounts. One pays 5.25%, with daily compounding. The other pays 5.3% with semiannual compounding. Which account should you use to deposit $100?
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 = $105.37
You have more money in the first account.
4-54
A reasonable question to ask in the above example is “what is the effective annual rate of interest on that investment?”
The Effective Annual Rate (EAR) of interest is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
93.70$)06.1(50$)2
12.1(50$ 632 FV
93.70$)1(50$ 3 EAR
4-55
Thus, EAR = (FV / PV)1/T – 1 (as in an earlier formula we developed for r)
So, investing at 12.36% compounded annually is the same as investing at 12% compounded semi-annually. Thus, EAR > APR due to compounding.
93.70$)1(50$ 3 EARFV
50$
93.70$)1( 3 EAR
1236.150$
93.70$31
EAR
4-56
Find the Effective Annual Rate (EAR) of an18% APR loan that is compounded monthly.
What we have is a loan with a monthly interestrate rate of 18/12 % = 1½ %.
This is equivalent to a loan with an annualinterest rate of 19.56%.
In other words, EAR = [1 + r/m]m – 1
1956.1)015.1(12
18.11 12
12
m
m
r
4-57
Texas Instruments BA-II Plus FV = future value
PV = present value
I/Y = periodic (annual) interest rate Interest will be compounded for number of periods
you enter in P/Y. Thus, P/Y must equal 1 for the I/Y to be the periodic (annual) rate.
Interest is entered as a percent, not a decimal
N = number of periods
Remember to clear the registers (CLR WORK) after each problem
Other calculators are similar in format
4-58
keys: description:
[2nd] [ICONV] Opens interest rate conversion menu
[↓] [EFF=] [CPT] 19.562
Texas Instruments BAII Plus
[↓][NOM=] 18 [ENTER] Sets 18 APR.
[↑] [C/Y=] 12 [ENTER] Sets 12 payments per year
4-59
Compound at every infinitesimal instant.
The general formula for the future value of an investment compounded continuously over many periods can be written as:
FV = C0×erT
(because lim(1 + r/m)m×T = erT when m converges to infinity), where:
C0 is cash flow at date 0, r is the stated annual interest rate, T is the number of years, and e is the base of the natural logarithms. e is approximately equal to 2.718. ex is a key on your calculator.
4-60
The EAR of a continuously compounded investment is:
EAR = er – 1
For example, say APR on a loan (cc) is 10%. Then EAR = e.1 – 1 = .1051709
4-61
Perpetuity
A constant stream of cash flows that lasts forever
Growing perpetuity
A stream of cash flows that grows at a constant rate forever
Annuity
A stream of constant cash flows that lasts for a fixed number of periods
Growing annuity
A stream of cash flows that grows at a constant rate for a fixed number of periods
4-62
A constant stream of cash flows that lasts forever
0
…1
C
2
C
3
C
32 )1()1()1( r
C
r
C
r
CPV
r
CPV
4-63
PV = C/(1+r)+PV/(1+r), i.e., PV(1-(1/1+r)) = C/(1+r),
i.e., PV = C/r
32 )1()1()1( r
C
r
C
r
CPV
4-64
What is the value of a British consol that promises to pay £15 every year for ever?
The interest rate is 10-percent.
0
…
1
£15
2
£15
3
£15
£15010.
£15PV
4-65
A stream of cash flows that grows at a constant rate forever
0
…
1
C
2
C×(1+g)
3
C ×(1+g)2
3
2
2 )1(
)1(
)1(
)1(
)1( r
gC
r
gC
r
CPV
gr
CPV
4-66
The expected dividend next year is $1.30, and dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this promised dividend stream?
0
…
1
$1.30
2
$1.30×(1.05)
3
$1.30 ×(1.05)2
00.26$05.10.
30.1$
PV
4-67
A constant stream of cash flows with a fixed maturity, i.e., a stream of constant cash flows that lasts for a fixed number of periods
0 1
C
2
C
3
C
Tr
C
r
C
r
C
r
CPV
)1()1()1()1( 32
Trr
CPV
)1(
11
T
C
4-68
If you can afford a $400 monthly car payment, how much car can you afford if interest rates are 7% on 36-month loans?
0 1
$400
2
$400
3
$400
59.954,12$)1207.1(
11
12/07.
400$36
PV
36
$400
4-69
Or use calculator
Press 2ND , P/Y
Enter 12 (for 12 periods per year)
Press ENTER
Press 2ND , QUIT
Enter 36, press N
Enter -400, press PMT
Enter 0, press FV
Enter 7, press I/Y
Press CPT, PV
4-70
A stream of cash flows that grows at a constant rate for a fixed number of periods
0 1
C
T
T
r
gC
r
gC
r
CPV
)1(
)1(
)1(
)1(
)1(
1
2
T
r
g
gr
CPV
)1(
11
2
C×(1+g)
3
C ×(1+g)2
T
C×(1+g)T-1
4-71
A defined-benefit retirement plan offers to pay $20,000 per year for 40 years and increase the annual payment by 3% each year. What is the present value at retirement if the discount rate is 10%?
0 1
$20,000
57.121,265$10.1
03.11
03.10.
000,20$40
PV
2
$20,000×(1.03)
40
$20,000×(1.03)39
4-72
Note that a growing annuity (of C that grows at rate g, interest rate r) has the same present value as an ordinary annuity of C* = C/(1+g) at an interest rate r* = [(1+r)/(1+g)]-1. Intuition: we adjust the interest rate and the cash flow for the growth rate.
Thus, C* = C/(1+g) = $20,000/1.03 = 19,417.476, r* = [(1+r)/(1+g)]-1 = (1.1/1.03)-1 = 6.79612%
(make sure P/Y=1), N=40, PMT=-19,417.476, FV=0, I/Y= 6.79612, PV=265,121.47 (small difference due to rounding up)
4-73
You want to receive $5,000 per month in retirement.
If you can earn .75% per month and you expect to
need the income for 25 years, how much do you
need to have in your account at retirement?
PMT = 5,000; N = 25*12 = 300; I/Y = .75; CPT PV = 595,808.11
4-74
Fred starts saving for retirement at age 25 by saving $100 per month. Joe starts at age 35. Both plan to retire at 65. If their retirement accounts earn 12% per year, how much will Joe have to save per month to have saved the same amount as Fred.
F: 40x12=480 months, J: 30x12=360 months
N=480, PMT=-100, PV=0 (they start with $0), I=12/12=1%, FV=1,176,477.85
N=360, PV=0, I=1%, FV=1,176,477.85, PMT=-336.62
4-75
Principal=original loan amount.
Pure Discount Loans are the simplest form of loan. The borrower receives money today and repays a single lump sum (principal and interest) at a future time.
Interest-Only Loans require an interest payment each period, with full principal due at maturity.
Amortized Loans require repayment of principal over time, in addition to required interest.
4-76
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 = 9,345.79
4-77
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.
4-78
Lender requires the borrower to repay parts of the loan amount over time.
Each payment covers the interest expense; plus, it reduces principal
The process of paying off a loan by making regular principal reductions is called amortizing the loan.
Two types:
Fixed principal payment per period
Fixed payment in total (principal plus interest) per
period
4-79
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
4-80
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?
4 N
8 I/Y
5,000 PV
CPT PMT = -1,509.60
Click on the Excel icon to see the amortization table
4-81
An investment is worth the present value of its future cash flows. Since a company is a series of investments,
conceptually, a firm should be worth the present value of the firm’s cash flows.
The tricky part is determining the size, timing, and risk of those cash flows.
4-82
How is the future value of a single cash flow computed?
How is the present value of a series of cash flows computed.
What is the Net Present Value of an investment?
What is an EAR, and how is it computed?
What is a perpetuity? An annuity?