Chapter 4

Discounted Cash Flow

Valuation
Basic Definitions

•PV : Present Value; the value of money now

•FV : Future Value; the value of money in future
(later)
•r : Interest rate ; “exchange rate” between
earlier money and later money
= Discount rate
= Cost of capital
= Opportunity cost of capital
= Required return

1
The Financial Market Economy

• Individuals and institutions have different income

streams and different inter-temporal consumption
preferences.
• Because of this, a market for money has arisen, the
Capital or Financial Market.
• When Supply = Demand => market is in equilibrium.
•The price of Capital (or Financial)
market is the interest rate
The Competitive Financial Market
•In a competitive market:
• Trading is costless.
• Information about borrowing and lending is
available
• There are many traders (borrowers/lenders); no
individual can influence market prices; no cartels
•Only one equilibrium interest rate exists;
•otherwise arbitrage (profit) opportunities
would arise.
Making Consumption Choices over Time

•An individual can alter his/her consumption

across time periods through borrowing and
lending.
•We can illustrate this by graphing
consumption today versus consumption in
the future.
•This graph will show intertemporal
consumption opportunities.
Intertemporal Consumption Opportunity
Set
A person with $95,000 who faces a 10% interest rate
Consumption at t+1
has the following opportunity set.
$120,000

$ 1 0 4 .5 = $ 9 5 ´ (1 .1 0 ) One choice is to consume $40,000 now;

$100,000
invest the remaining $55,000; consume
$60,500 next year.
$80,000

$60,500 = $55,000 ´ (1.10)1

$60,000

$40,000

$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption today
Taking Advantage of Our Opportunities
Consumption at t+1
A person’s preferences will tend to
$120,000 decide where on the opportunity
set they will choose to be.
$100,000
Ms. Patience (China???)
$80,000

$60,000

$40,000
Ms. Impatience
(USA???)
$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption today
 Changing Our Opportunities
Consumption at t+1 Consider an investor who has chosen to
consume $40,000 now and to consume
$120,000
$55,000(1.1) = $60,500 next year.

$100,000 A rise in interest rates will make saving

more attractive …
$80,000

$60,000 …and borrowing less attractive.

$40,000

$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption today
 The Basic Principle

• The basic financial principle of investment decision

making is this:
•An investment must be at least as good
as all available opportunities in the
financial markets.
• The available opportunities are assumed to have a
“general” return (=r), with which they are compared
Practicing the Principle: A Lending Example
Consider an investment opportunity that costs
$50,000 this year and provides a certain cash
flow of $54,000 next year.
$54,000
Cash inflows
Time 0
Cash outflows 1

-$50,000
Is this a good deal?
It depends on the interest rate available in the market.
Since it has an implicit 8% return, if the interest rate
available elsewhere is less than this, it is a good deal!
 FV: General Formula

FV = PV(1 + r)t

• FV = future value
• PV = present value
• r = period interest rate, expressed as a decimal
• t = number of periods
•FV interest factor = (1 + r)t

10
 Compounding Periods

Sometimes interest is charged more frequently than

once per year

Semi-
Quarterly Monthly Weekly (52 Daily (365
Annually
(4 times a (12 times a times a times a Continuous
(2 times a year year)
year) year)
year)
 Formula for frequent
compounding
• Compounding an investment m times a year provides end-
of-year wealth of:
m
æ rö
C0 ç1 + ÷
è mø
where C0 is the initial investment and r is the stated Annual
Interest Rate (AIR).
• The stated annual interest rate is the AIR without
consideration of compounding.
 Effective Annual Rate
• What is the end-of-year wealth if Christine receives a stated
AIR of 24% compounded monthly on a €1 investment?

12
æ .24 ö 12
€1ç1 + ÷ = €1 ´ (1.02)
è 12 ø
= €1.2682

• The annual rate of return is 26.82 %, i.e. this is the Effective

Annual Rate (EAR)
• Due to compounding, EAR > AIR
 EAR – Formula (one period)

m
é rù
EAR = ê1 + ú - 1= e - 1
r

ë mû
t
é 1ù
e = limt ®¥ ê1 + t ú » 2.71828...
ë û

14
 Compounding over Many
Years

mT
æ rö
FV = C0 ç 1 + ÷
è mø

FV = PV( e ) rt
 Present Value
• How much do I have to invest today to get a
certain amount in the future?
FV
FV = PV ( 1 + r) Þ PV =
t

( 1 + r)t
• When we talk about discounting, we mean finding
the PV or the future amount.

16
Perpetuity Formula (check notes too)

Perpetuity (or Concol) is a constant stream

of cash flows (C) that never ends.

C C
PV = + + ... +
(1+ r ) (1+ r ) 2

C C
=
(1+ r )t
r
 Perpetuities

• Consider a perpetuity paying £100 per year. If the

relevant interest rate is 8 %, what is the present
value of the perpetuity?

£100
PV = = £1, 250
.08
Growing Perpetuity (g = growth rate of C)
(check the notes)
A perpetuity in which the cash flows (=C)
grows with a constant g for ever, for r > g

C
PV =
r- g
 Growing Perpetuities

• Imagine an apartment building where cash flows to

the owner after expenses will be €100,000 next
year. These cash flows are expected to rise at 5 %
per year. The relevant interest rate is 11 %. What is
the PV of the cash flows?

€100, 000
= €1, 666, 667
.11 - .05
 Annuity Formula (check notes!)

Annuity is a level stream of cash flows (C)

that last for a fixed number of periods (years)

é1 1 ù
PV = C ê - T ú
ë r r( 1 + r ) û
 Lottery Valuation

• Mark has just won a competition paying £50,000 a year for 20

years. He is to receive his first payment a year from now. The
competition organizers advertises this as the Million Pound
Competition because £1,000,000 = £50,000 ´ 20. If the interest
rate is 8 %, what is the true value of the prize?

é 1 1 ù
PV of 1 mil. = 50 ê - 20 ú
ë 0.08 0.08( 1 + 0.08 ) û
= 490,905
 The FV of an Annuity Formula
(check notes)

FV = C
é (1 + r )T 1 ù
-
êë r rú
û
=C
é (1 + r ) T - 1ù
êë r úû
 Retirement Investing

• Suppose you put £3,000 per year into a Cash Investment

Savings Account. The account pays 6% interest per year, tax-
free. How much will you have when you retire in 30 years?

é (1 + r ) T - 1 ù = £3,000 é 1.0630 - 1 ù
FV = C ê .06 ú
êë r úû ë û
= £3,000 ´ 79.0582
= £237,174.56
 Retirement Investing

•You have saved as a whole:

• £3,000 per year X 30 years = £90,000

• Notice that if you saved all £90,000 now, it

would increase to much higher:

FV = 90, 000(1.06)30 = £516, 914

 A Delayed Annuity (old exam)
• Danielle will receive a 4-year annuity of €500 per year,
beginning at year 6. If the interest rate is 10 %, what is the PV
of her annuity? How do you do it?

1. First, discount annuity back to year 5, i.e. treat year 5 as

a “Present”, i.e. find the PV at year 5.
2. Discount then year 5 value of annuity back to year 0
(now)
 A Delayed Annuity
• Step 1: Discount annuity to year 5

é 1 1 ù
500 ê - 4ú
ë 0.1 0.1( 1 + 0.1 ) û
= 1584.95
• Step 2: Discount year 5 value back to year 0

€1, 584.95
= €984.13
5
(1.10)
 Equating the PV of Two
Annuities (old exam)
• Harold and Helen Nash are saving for the university
education of their newborn daughter, Susan. The
Nashes estimate that university expenses will be
€30,000 per year (for each of 4 years), when their
daughter starts university in 18 years. The annual
interest rate over the next few decades will be 14 %.
How much money must they deposit in the bank each
year, over 17 years, so that their daughter will be
completely supported through her four years at
university?
 Equating the PV of Two Annuities

1. Treat year 17 as PV and calculate that value of the university

payments (at years 18 – 21, i.e. 4 years)
2. Calculate then the true PV which occurs at year 0 (simply
discount the value above)
3. Use the annuity formula to calculate the unknown cash flow (all
17 years of savings) that have the same PV as above (step 2)
and solve for C
 Equating the PV of Two Annuities

• 1.
30 ,000 é 1 ù
ê1- 4ú
= €87 ,411
0.14 ë ( 1 + 0.14 ) û

• 2. €87, 411
17
= €9, 422.91
(1.14)

• 3. C é 1 ù
9 ,422.91 = ê1- 17 ú
=> C = €1,478.59
0.14 ë ( 1 + 0.14 ) û
 Equating the PV of Two Annuities (check)

1. In year 17, the FV of annuity of 1,478.6 (i.e. if they

save every year that amount) = 87,411.3
2. In year 18, just before the first payment, it grows to
99,648.5 and after paying 30,000 it is 69,648.5 left.
3. Continue similarly, it will grow to 79,399.3 and after
paying 30,000 it is 49,399.3 left; it will grow to
56,313.3 and after paying 30,000 it is 26,313.3 left;
finally it will grow to 30,000 which is paid out and
the remaining value is zero.
 Growing Annuity

é æ1+ g ö
T ù
ê1 - ç ÷ ú
ê è 1+ r ø ú
PV = C
ê r-g ú
ê ú
ê
ë ú
û

Derivation is given in textbook (or in my Notes)

 More Growing Annuities
• In a previous example, imagine that the Nash family
planned to increase their payments at 4 % per year.
What would their first payment be?
• The first two steps showed that the PV of the 4 year
university costs was €9,422.91. These two steps
would be the same here.
• The third step must be altered. Now we must ask,
how much should their first payment be so that, if
payments increase by 4 % per year, the PV of all
payments will be €9,422.91?
 More Growing Annuities

• Set the growing annuity formula to €9,422.91 and solve for C:

é æ1+ g ö ùT é æ 1.04 ö
17 ù
ê1 - ç 1+ r ÷ ú ê1 - ç ÷ ú
Cê è ø ú =Cê è 1.14 ø ú = €9, 422.91
ê r-g ú ê .14 - .04 ú
ê ú ê ú
êë úû êë úû

• Here, C = €1,192.78, which is obviously lower!

 What is a Firm Worth?

• A firm is expected to generate net cash flows (cash inflows minus

cash outflows) of £5,000 in the first year and £2,000 for each of the
next five years. The firm can be sold for £10,000 seven years from
now. The owners of the firm would like to be able to make 10 % on
their investment in the firm. What is the value of the firm today?
 What is a Firm Worth?
The PV of the Firm
End of Net Cash PV PV of
Year Flow Factor Net Cash
of the Firm (10%) Flows
1 £ 5,000 .90909 £ 4,545.45
2 2,000 .82645 1,652.90
3 2,000 .75131 1,502.62
4 2,000 .68301 1,366.02
5 2,000 .62092 1,241.84
6 2,000 .56447 1,128.94
7 10,000 .51316 5,131.58
PV £16,569.35
 Firm Valuation

• Daniele’s Pizza Company is contemplating investing €1

million in four new outlets in Italy. Massimiliano Barbi, the
firm’s chief financial officer (CFO), has estimated that the
investments will pay out cash flows of €200,000 per year for
nine years and nothing thereafter. (The cash flows will occur
at the end of each year and there will be no cash flow after
year 9.) Mr. Barbi has determined that the relevant discount
rate for this investment is 15 %. This is the rate of return that
the firm can earn at comparable projects.
• Should Daniele make the investments in the new outlets?
 Firm Valuation

€200, 000 €200, 000 … €200, 000

NPV = - €1, 000, 000 + + 2
+ +
1.15 (1.15) (1.15)9
= - €1, 000, 000 + €200, 000 ´ A.915
= - €1, 000, 000 + €954,316.78
= - €45, 683.22
 Annuity Due

• Mark Young receives £50,000 a year for 20 years from a

competition. Assume that the first payment occurs
immediately and that the discount rate is 8 %. What is the
value of the prize?
£50,000 + £50,000 ´ A19
.08
Payment at date 0 19-year annuity
=£50,000 + (£50,000 ´ 9.6036)

=£530,180
 Infrequent Annuities
• Ann Chen receives an annuity of £450, payable once every
two years. The annuity stretches out over 20 years. The first
payment occurs at date 2— that is, two years from today.
The annual interest rate is 6 %. What is the value of this
annuity?
• Determine the interest rate over a two-year period.
• (1.06 ´ 1.06) - 1 = 12.36%
• Now calculate the PV of a £450 annuity over 10 periods, with
an interest rate of 12.36 % per period:
é 1 ù
ê 1 - (1 + .1236)10 ú
£450 ê ú = £450 ´ A.10
1236 = £2,505.57
ê .1236 ú
êë úû
 Growing Annuities

• Stuart Gabriel, a second-year MBA student, has just been

offered a job at £80,000 a year. He anticipates his salary
increasing by 9 % a year until his retirement in 40 years.
Given an interest rate of 20 %, what is the PV of his lifetime
salary?
é æ 1.09 ö
40 ù
ê1- ç 1.20 ÷ ú
£80,000 ´ ê è ø ú = £711, 730.71
ê .20 - .09 ú
ê ú
êë úû
 Computing annual rates from EARs

• If you have an effective rate, how can you compute the

Annual rate?
• Take the power 1/m of both sides of EAR
• Simplify, rearrange and get:
m(1/m)
é rù (1/m)
(EAR)1/m = ê1 + ú - [1 ]
ë mû
é 1 ù
m
r = m (1 + EAR) - 1
êë úû
42
 Multi-Year Compounding

• Harry De Angelo is investing €5,000 at a stated AIR of 12% per year,

compounded quarterly, for 5 years. What is his wealth at the end of 5
years?

4´5
æ .12 ö 20
€5, 000 ´ ç1 + ÷ = €5, 000 ´ (1.03)
è 4 ø
= €5, 000 ´ 1.8061 = €9, 030.50