Topic

Discounted cash flows

Introduction to Financial
Management course

By Dr. Nguyen Thu Hien

Modified from slides by Ross, Westerfield, Jordan, 0

“Fundamentals of Corporate Finance”, 7th ed., McGraw-Hill Irwin

Chapter Outline
l Future and Present Values of Multiple Cash
Flows
l Valuing Level Cash Flows: Annuities and
Perpetuities
l Comparing Rates: The Effect of
Compounding
l Loan Types and Loan Amortization

1
Future Value of
Multiple Cash Flows- Example 1
l You think you will be able to deposit $4,000 at the end
of each of the next three years in a bank account
paying 8 percent interest. You currently have $7,000 in
the account. How much will you have in three years?
In four years?

l Year 0: 7000
l Year 1: 4000
l Year 2: 4000
l Year 3: 4000 FV3?

2
Present Value of
Multiple Cash Flows- Example 1
l You are offered an investment that will pay you $200 in
one year, $400 in two years, $600 in three years, and
$800 in four years. You can earn 12 percent on very
similar investments. What is the most you should pay for
this one?

§ 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

6
Example 6.3 Timeline
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1432.93

7
Decisions, Decisions
l Your broker calls you and tells you that he has this great
investment opportunity. If you invest $100 today, you will receive
$40 in one year and $75 in two years. If you require a 15% return
on investments of this risk, should you take the investment?

§ CF: CF0 = -100; CF1 = 40; CF2 = 75

§ I = 15;
§ è NPV = -8.51

l No – the broker is charging more than you would be

willing to pay. 10
Saving For Retirement
l You are offered the opportunity to put some
money away for retirement. You will receive
five annual payments of $25,000 each
beginning in 40 years. How much would you
be willing to invest today if you desire an
interest rate of 12%?

§ CF: CF40 =CF41 = CF42 = CF43 = CF44 = 25,000;

§ I = 12; è NPV = 1084.71
11
Saving For Retirement Timeline

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)

The cash flows years 1 – 39 are 0
The cash flows years 40 – 44 are 25,000

12
Quick Quiz – Part I
l 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%
l What is the value of the cash flows at year 5?
l What is the value of the cash flows today?
l What is the value of the cash flows at year 3?

13
Annuities and Perpetuities
Defined
l Annuity – finite series of equal payments that
occur at regular intervals
Ordinarry
Annuity

0 1 2 3 4

PV(AD) = PV(OA) * (1+r)

Annuity FV(AD) = FV(OA) * (1+r)
Due
0 1 2 3 4

l Perpetuity – infinite series of equal payments

Perpetuity

0 1 2 3 4 14
¥
Annuities and Perpetuities –
Basic Formulas
l Ordinary Annuities:
é 1 ù
ê1 - (1 + r ) t ú
PV = C ê ú
ê r ú
ê
ë ú
û
é (1 + r ) t - 1 ù
FV = C ê ú
ë r û

PV=C/(1+r) +C/(1+r)2 + C/(1+r)3 +…+ C/(1+r)n

l Perpetuity: PV = C / r
15
Annuity – Example
l After carefully going over your budget, you
have determined you can afford to pay $632
per month toward a new sports car. You call
up your local bank and find out that the going
rate is 1 percent per month for 48 months.
How much can you borrow?
l Formula: é 1 ù
ê1 - (1.01) 48 ú
PV = 632 ê ú = 23,999.54
ê .01 ú
êë úû
16
Quick Quiz – Part II
l You know the payment amount for a loan and
you want to know how much was borrowed.
Do you compute a present value or a future
value?
l You want to receive 5000 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?
19
Finding the Payment
l Suppose you want to borrow $20,000 for a
new car. You can borrow at 8% per year. If
you take a 4 year loan, what is your annual
payment?

§ N=4; PV=20,000; I=8; è PMT= -6,038.42

20
Finding the Number of Payments –
Example
l 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.
§ Formula:
§ 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 22
Finding the Rate
l Suppose you borrow $10,000 from your
parents to buy a car. You agree to pay
$207.58 per month for 50 months. What is
the monthly interest rate?

§ N=50
§ PV=10,000
§ PMT=-207.58 è I= .15%

§ Using Shift + SOLVE on Casio/Vinacal calculator 24

Quick Quiz – Part III
l 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?
l What monthly rate would you need to earn if you
only have $200,000 to deposit?
l Suppose you have $200,000 to deposit and can
earn .75% per month.
l How many months could you receive the $5000
payment?
l How much could you receive every month for 5 years?

26
Future Values for Annuities
l Suppose you begin saving for your retirement
by depositing $2000 per year in an IRA. If the
interest rate is 7.5%, how much will you have
in 40 years?

§ 40 N
§ 7.5 I/Y
§ -2000 PMT
§ CPT FV = 454,513.04

27
Annuity Due
l You are saving for a new house and you put $10,000 per year for
three years in an account paying 8%. The first payment is made
today. How much will you have at the end of 3 years?

§ Compute PV using (OA) formula (PV-1); then convert to FV3

§ Or: Directly compute FV3 using modified FV formula:
FV = 10,000[(1.083 – 1) / .08](1.08) = 35,061.12

l What if it were an ordinary annuity?

FV = 32,464 (so receive an additional 2597.12 by starting to save
today.)

28
Annuity Due Timeline
0 1 2 3

10000 10000 10000

32,464

35,016.12
29
Perpetuity – Example 6.7
l Suppose the Fellini Co. wants to sell
preferred stock at $100 per share. What
dividend will Fellini have to offer if the market
requires an interest rate of 2.5% per quarter?
§ Stock price = 100 = PV(future benefits) = C/r = C/2.5%
§ è C = 100$ * 2.5% = 2.5$ per quarter.
§ Dividend for new preferred:
§ 100 = C / .025
§ C = 2.50 per quarter

30
Quick Quiz – Part IV
l You want to have $1 million to use for
retirement in 35 years. If you can earn 1%
per month, how much do you need to deposit
on a monthly basis if the first payment is
made in one month?
l What if the first payment is made today?
l 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?
31
Summary of formulas

32
Annual Percentage Rate
(nominal rate)
l This is the annual rate that is quoted at banks
l By definition APR = period rate times the
number of periods per year
l Consequently, to get the period rate we
rearrange the APR equation:
l Period rate = APR / number of periods per year

33
Computing APRs
l What is the APR if the monthly rate is .5%?
l .5(12) = 6%
l What is the APR if the semiannual rate is
.5%?
l .5(2) = 1%
l What is the monthly rate if the APR is 12%
with monthly compounding?
l àm=12à i=1%

34
Effective Annual Rate (EAR)
l This is the actual rate paid (or received) after
accounting for compounding that occurs during the
year
l If you want to compare two alternative investments
with different compounding frequencies you need to
compute the EAR and use that for comparison.

35
Computing EAR
12% compounded annually 12% compounded monthly
(interest at end of the year) (interest at the end of each month)
l At end of year: l At end of year: 100,000
100,000+12,000
l Every month: 0 l Every month: 1,000
l FV=PV*(1+12%)1 l FV = PV*(1+1%)12
l RR = (FV-PV)/PV= l RR = FV/PV -1 =
FV/PV-1 (1+1%)12-1 =12.68%
= 1+12%-1 = 12% l EAR>APR
l EAR = APR (because m>1)
(because m=1) l EAR1-year = (1+APR/m)m-1
l EARn = (1+APR/m)m*n-1 36
EAR - Formula
m
é APR ù
EAR = ê1 + ú - 1
ë m û
Remember that the APR is the quoted rate
m is the number of compounding periods per year

37
Computing EARs - Example
l Suppose you deposit $1 in an account that earns
1% per month.
l What is the APR? 1(12) = 12%
l How much are you effectively earning?
l FV = 1(1.01)12 = 1.1268
l Rate = (1.1268 – 1) / 1 = .1268 = 12.68%

l Now, suppose if you put it in another account that

earns 3% per quarter.
l What is the APR? 3(4) = 12%
l How much are you effectively earning?
l FV = 1(1.03)4 = 1.1255
l Rate = (1.1255 – 1) / 1 = .1255 = 12.55%
38
Decisions, Decisions II
l 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?
l First account:
l EAR = (1 + .0525/365)365 – 1 = 5.39%
l Second account:
l EAR = (1 + .053/2)2 – 1 = 5.37%
l Which account should you choose and why?

39
Decisions, Decisions II
Continued
l Let’s verify the choice. Suppose you invest
$100 in each account. How much will you
have in each account in one year?
l First Account:
l 365 N; 5.25 / 365 = .014383562 I/Y; 100 PV; CPT FV
= 105.39
l Second Account:
l 2 N; 5.3 / 2 = 2.65 I/Y; 100 PV; CPT FV = 105.37
l You have more money in the first account.
40
Computing APRs from EARs
l If you have an effective rate, how can you
compute the APR? Rearrange the EAR
equation and you get:

é
APR = m (1 + EAR)
1
m
-1ù
êë úû

41
Calculating APR - Example
l 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 = .1138655152
or 11.39%

42
Monthly compounding
l Suppose you want to buy a new computer
system and the store is willing to sell it and
allow you to make monthly payments. The
entire computer system costs $3500. The
loan period is for 2 years and the interest rate
is 16.9% with monthly compounding. What is
your monthly payment? EAR? APR for 2
years? EAR for 2 years?
l 2(12) = 24 N; 16.9 / 12 = 1.408333333 I/Y; 3500
PV; CPT PMT = -172.88
43
Daily Compounding
l You need $15,000 in 3 years for a new car. If
you can deposit money today into an account
that pays an APR of 5.5% based on daily
compounding, how much would you need to
deposit?
l 3(365) = 1095 N
l 5.5 / 365 = .015068493 I/Y
l 15,000 FV
l CPT PV = -12,718.56
45
Continuous Compounding
l Sometimes investments or loans are figured
based on continuous compounding
l EAR = eq – 1
l The e (= 2.7184) is a special function on the
calculator normally denoted by ex
l q: quoted rate APR

l Example: What is the effective annual rate of

7% compounded continuously?
l EAR = e.07 – 1 = .0725 or 7.25%
46
Quick Quiz – Part V
l What is the definition of an APR?
l What is the effective annual rate?
l Which rate should you use to compare
alternative investments or loans?
l Which rate do you need to use in the time
value of money calculations?

47
Types of loans
1. Pure Discount Loans
2. Interest-Only Loan
3. Amortized Loan with Fixed Principal
Payment
4. Amortized Loan with Fixed Payment

48
1. Pure Discount Loans
l Treasury bills (T-bills) are excellent examples
of pure discount loans. The principal amount
is repaid at some future date, without any
periodic interest payments.
l 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?
l 1 N; 10,000 FV; 7 I/Y; CPT PV = -9,345.79
49
l Government: issue bonds 5 year life
l Wait until end 5 year receive face value of
bond.
l Issuing price of bonds/bills/notes should be a
discount from the face value

50
2. Interest-Only Loan
l Consider a 5-year, interest-only loan with a
7% interest rate. The principal amount is
$10,000. Interest is paid annually.
l What would the stream of cash flows be?
l Years 1 – 4: Interest payments of .07(10,000) = 700
l Year 5: Interest + principal = 10,700
l This cash flow stream is similar to the cash
flows on corporate bonds and we will talk
about them in greater detail later.
51
3. Amortized Loan with Fixed
Principal Payment
l 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.
l Click on the Excel icon to see the
amortization table

52
 3. Amortized Loan with Fixed
Principal Payment (cond.)
Beginning Interest Principal Total Ending
Year Balance Payment Payment Payment Balance

1 50,000 4,000 5,000 9,000 45,000

2 45,000 3,600 5,000 8,600 40,000

3 40,000 3,200 5,000 8,200 35,000

4 35,000 2,800 5,000 7,800 30,000

5 30,000 2,400 5,000 7,400 25,000

6 25,000 2,000 5,000 7,000 20,000

7 20,000 1,600 5,000 6,600 15,000

8 15,000 1,200 5,000 6,200 10,000

9 10,000 800 5,000 5,800 5,000

53
10 5,000 400 5,000 5,400 0
4. Amortized Loan with Fixed Payment

l Each payment covers the interest expense plus

reduced principal
l Consider a 4 year loan with annual payments. The
interest rate is 8% and the principal amount is
$5000.
l What is the annual EQUAL payment?
l 4N

l 8 I/Y
l 5000 PV
l CPT PMT = -1,509.60

l Click on the Excel icon to see the amortization table

54
4. Amortized Loan with Fixed
Payment (cond.)
Year Beginning Total Interest Principal Ending
balance payments payments balance

1 5,000.00 1,509.60 400.00 1,109.60 3,890.40

2 3,890.40 1,509.60 311.23 1,198.37 2,692.03

3 2,692.03 1,509.60 215.36 1,294.24 1,397.79

4 1,397.79 1,509.60 111.82 1,397.78 0.01

Totals 6,038.40 1,038.41 4,999.99

55
Quick Quiz – Part VI
l What is a pure discount loan? What is a good
example of a pure discount loan?
l What is an interest-only loan? What is a good
example of an interest-only loan?
l What is an amortized loan? What is a good
example of an amortized loan?

57
Basics of Chapter
l PV, FV of multiple cash flows
l Anuity and Perpetuity
l Effect of frequency of compounding
l APR and EAR
l Types of loans

58