CHAPTER 4: DISCOUNTED CASH FLOW VALUATION

Solutions to Questions and Problems

NOTE: All-end-of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.

Please see the last page for additional illustrations of the annuity formulas

2. To find the FV of a lump sum, we use:

FV = PV(1 + r)t

a.
0 10

$1,250 FV

FV = $1,250(1.05)10 = $2,036.12

b.
0 10

$1,250 FV

FV = $1,250(1.10)10 = $3,242.18
c.
0 20

$1,250 FV

FV = $1,250(1.05)20 = $3,316.62

d. Because interest compounds on the interest already earned, the interest earned in part c is more
than twice the interest earned in part a. With compound interest, future values grow
exponentially.

5. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV/PV)/ln(1 + r)
 0 ?

–$625 $1,104

FV = $1,104 = $625(1.07)t; t = ln($1,104/$625)/ln 1.07 = 8.41 years

0 ?

–$810 $5,275

FV = $5,275 = $810(1.112)t; t = ln($5,275/$810)/ln 1.12 = 16.53 years

0 ?

–$16,500 $245,830

FV = $245,830 = $16,500(1.17)t; t = ln($245,830/$16,500)/ln 1.17 = 17.21 years

0 ?

–$21,500 $215,000

FV = $215,000 = $21,500(1.08)t; t = ln($215,000/$21,500)/ln 1.08 = 29.92 years

9. The time line is:

0 1 ∞
…
PV $75 $75 $75 $75 $75 $75 $75 $75 $75

A consol is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C/r
PV = $75/.031
PV = $2,419.35

10. To find the future value with continuous compounding, we use the equation:

FV = PVert

a.
0 9

$2,350 FV

FV = $2,350e0.12(9) = $6,920.00

b.
0 5

$2,350 FV

FV = $2,350e0.08(5) = $3,505.79

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 c.
0 17

$2,350 FV

FV = $2,350e0.05(17) = $5,498.17

d.
0 10

$2,350 FV

FV = $2,350e0.09(10) = $5,780.07

12. The times lines are:

0 1 2 3 4 5 6 7 8 9

PV $4,350 $4,350 $4,350 $4,350 $4,350 $4,350 $4,350 $4,350 $4,350

0 1 2 3 4 5

PV $6,900 $6,900 $6,900 $6,900 $6,900

To find the PVA (Present Value of an Annuity), we use the equation:

!
!"
(!#$)&
PVA = C! "= C({1 – [1/(1 + r)t]}/r)
#

At an interest rate of 5 percent:

X@5%: PVA = $4,350{[1 – (1/1.05)9]/.05} = $30,919.02

Y@5%: PVA = $6,900{[1 – (1/1.05)5]/.05} = $29,873.39

And at an interest rate of 22 percent:

X@22%: PVA = $4,350{[1 – (1/1.22)9]/.22} = $16,470.34

Y@22%: PVA = $6,900{[1 – (1/1.22)5]/.22} = $19,759.11

Notice that the PV of Cash flow X has a greater PV than Cash flow Y at an interest rate of 5 percent,
but a lower PV at an interest rate of 22 percent. The reason is that X has greater total cash flows. At a
lower interest rate, the total cash flow is more important since the cost of waiting (the interest rate) is
not as great. At a higher interest rate, Y is more valuable since it has larger cash flows. At a higher
interest rate, these bigger cash flows earlier are more important since the cost of waiting (the interest
rate) is so much greater.

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15. For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR/m)]m – 1

EAR = [1 + (.071/4)]4 – 1 = .0729, or 7.29%

EAR = [1 + (.132/12)]12 – 1 = .1403, or 14.03%

EAR = [1 + (.089/365)]365 – 1 = .0931, or 9.31%

To find the EAR with continuous compounding, we use the equation:

EAR = er – 1
EAR = e.081 – 1 = .0844, or 8.44%

21. To find the FV of a lump sum with discrete compounding, we use:

FV = PV(1 + r)t

a.
0 11

$1,000 FV

FV = $1,000(1.089)11 = $2,554.50
b.
0 22

$1,000 FV

FV = $1,000(1 + .089/2)22 = $2,606.07

c.
0 132

$1,000 FV

FV = $1,000(1 + .089/12)132 = $2,652.19

d.
0 11

$1,000 FV

To find the future value with continuous compounding, we use the equation:

FV = PVert
FV = $1,000e.089(11) = $2,661.79

e. The future value increases when the compounding period is shorter because interest is earned on
previously accrued interest. The shorter the compounding period, the more frequently interest is
earned, and the greater the future value, assuming the same stated interest rate.

4
26. This is a growing perpetuity. The present value of a growing perpetuity is:

PV = C/(r – g)
PV = $175,000/(.097 – .038)
PV = $2,966,101.69

It is important to recognize that when dealing with annuities or perpetuities, the present value equation
calculates the present value one period before the first payment. In this case, since the first payment is
in two years, we have calculated the present value one year from now. To find the value today, we
discount this value as a lump sum. Doing so, we find the value of the cash flow stream today, which
is:

PV = FV/(1 + r)t
PV = $2,966,101.69/(1 + .097)1
PV = $2,703,830.17

28. The time line is:

0 1 2 3 4 5 6 7 30
…
PV $7,300 $7,300 $7,300 $7,300 $7,300 $7,300 $7,300

We can use the PVA annuity equation to answer this question. The annuity has 28 payments, not 27
payments. Since the first is payment made in Year 3, the present value of an annuity formula gives the
value of the annuity in Year 2, which is:

PVA = C({1 – [1/(1 + r)]t}/r)

PVA = $7,300({1 – [1/(1 + .07)]28}/.07)
PVA = $88,600.91

This is the value of the annuity one period before the first payment, or Year 2. So, the value of the
cash flows today is:

PV = FV/(1 + r)t
PV = $88,600.91/(1 + .07)2
PV = $77,387.47

34. Since your salary grows at 3.7 percent per year, your salary next year will be:

Next year’s salary = $74,500(1 + .037)

Next year’s salary = $77,256.50

This means your deposit next year will be:

Next year’s deposit = $77,256.50(.05)

Next year’s deposit = $3,862.83

Since your salary grows at 3.7 percent, your deposit will also grow at 3.7 percent. We can use the
present value of a growing annuity equation to find the value of your deposits today. Doing so, we
find:

5
 PV = C{[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}
PV = $3,862.83{[1/(.094 – .037)] – [1/(.094 – .037)] × [(1 + .037)/(1 + .094)]40}
PV = $59,798.32

Now, we can find the future value of this lump sum in 40 years. We find:

FV = PV(1 + r)t
FV = $59,798.32(1 + .094)40
FV = $2,174,612.53

This is the value of your savings in 40 years.

49. a. The time line for the ordinary annuity is:

0 1 2 3 4 5

PV $13,250 $13,250 $13,250 $13,250 $13,250

If the payments are in the form of an ordinary annuity, the present value will be:

PVA = C({1 – [1/(1 + r)t]}/r))

PVA = $13,250[{1 – [1/(1 + .078)]5}/.078]
PVA = $53,183.45

The time line for the annuity due is:

0 1 2 3 4 5

PV
$13,250 $13,250 $13,250 $13,250 $13,250

If the payments are an annuity due, the present value will be:

PVAdue = (1 + r) PVA
PVAdue = (1 + .078)$53,183.45
PVAdue = $57,331.76

Additional Problem provided in the email

You are buying a car costing $20,000 with a 15% down payment and a loan of the remaining
85% of the cost of the car. The APR on the loan is 6%, and the repayment is in equal monthly
installments over the next 3 years. What is the amount of the monthly payment? If you can afford
to make a maximum monthly payment of $400, what is the maximum loan amount you can take?

Loan Amount = 0.85 x $20,000 = $17,000 = Present Value of the Loan Payments (PVA)

Monthly interest rate = APR/12 = 0.06/12 = 0.005 = 0.5%

Number of monthly payments = 3 x 12 = 36

6
PVA = C({1 – [1/(1 + r)t]}/r))
17000 = C[{1 – [1/(1 + .005)]36}/.005]
17000 = C x 32.871016
C = 17000/32.871016
C = $517.17 (Monthly Payment)

If monthly payment = $400, what is the maximum loan amount?

PVA = C({1 – [1/(1 + r)t]}/r))

PVA = 400[{1 – [1/(1 + .005)]36}/.005]
PVA = 400 x 32.871016
PVA = $13,148.41 (Maximum Loan Amount)

For an annuity

PVIFA: Present Value Interest Factor for an Annuity

!
!"
(!#$)&
𝑃𝑉𝐼𝐹𝐴 = ! " = ({1-[1/(1+r)t]}/r)
#

(Two alternate ways of writing the formula)

Or

! &
!"$(!#$)%
𝑃𝑉𝐼𝐹𝐴 = * + = ({1-[1/(1+r)]t}/r)
#

(Two alternate ways of writing the formula)

For a growing annuity

PVIFGA: Present Value Interest Factor for a Growing Annuity

(!#' &
!"&(!#$)'
𝑃𝑉𝐼𝐹𝐺𝐴 = - . = [(1-{(1+g)/(1+r)}t)/(r-g)]
(#"))

(Two alternate ways of writing the formula)

Or

7
 1 1 (1 + 𝑔) +
𝑃𝑉𝐼𝐹𝐺𝐴 = /0 7 − 0 7x9 ; <
(𝑟 − 𝑔) (𝑟 − 𝑔) (1 + 𝑟)

= {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

(Two alternate ways of writing the formula)