Chapter 6

Formulas

Discounted Cash
Flow Valuation

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 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

6F-2
 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

6F-3
 Multiple Cash Flows –Future
Value Example 6.1
• Find the value at year 3 of each cash
flow and add them together
– Today (year 0): FV = 7000(1.08)3 = 8,817.98
– Year 1: FV = 4,000(1.08)2 = 4,665.60
– Year 2: FV = 4,000(1.08) = 4,320
– Year 3: value = 4,000
– Total value in 3 years = 8,817.98 + 4,665.60 +
4,320 + 4,000 = 21,803.58
• Value at year 4 = 21,803.58(1.08) =
23,547.87

6F-4
 Multiple Cash Flows – FV
Example 2
• 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) = 1,248.05

6F-5
Multiple Cash Flows – Present
Value Example 6.3
• 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 = 1,432.93

6F-6
 Example 6.3 Timeline
0 1 2 3 4

200 400 600 800

318.88

427.07

508.41
1,432.93

6F-7
 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

6F-8
Annuities and Perpetuities –
Basic Formulas
• Perpetuity: PV = C / r
• Annuities:

 1 
1 
(1  r ) t 
PV  C  
 r 

 

 (1  r ) t  1 
FV  C  
 r 

6F-9
 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

6F-10
Future Values for Annuities
• Suppose you begin saving for your
retirement by depositing $2,000 per
year in a retirement account. If the
interest rate is 7.5%, how much will
you have in 40 years?
– FV = 2,000(1.07540 – 1)/.075 =
454,513.04

6F-11
 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

6F-12
Annuity Due Timeline
0 1 2 3

10000 10000 10000

32,464

35,016.12

6F-13
Table 6.2

6F-14
 Growing Annuity
A growing stream of cash flows with a fixed maturity

t 1
C C  (1  g ) C  (1  g )
PV   
(1  r ) (1  r ) 2
(1  r ) t

C   (1  g )  
t

PV  1    
r  g   (1  r )  
 

6F-15
 Growing Annuity: Example
A defined-benefit retirement plan offers to pay
$20,000 per year for 40 years and increase the
annual payment by three-percent each year. What
is the present value at retirement if the discount
rate is 10 percent?

$20,000   1.03  
40

PV  1      $265,121.57
.10  .03   1.10  

6F-16
 Growing Perpetuity
A growing stream of cash flows that lasts forever

C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2
(1  r ) 3

C
PV 
rg

6F-17
 Growing Perpetuity:
Example
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?

$1.30
PV   $26.00
.10  .05

6F-18
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.

6F-19
 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
• Consequently, to get the period rate we rearrange
the APR equation:
– Period rate = APR / number of periods per year
• You should NEVER divide the effective rate by
the number of periods per year – it will NOT give
you the period rate

6F-20
 Computing APRs
• 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%
• What is the monthly rate if the APR is 12% with
monthly compounding?
– 12 / 12 = 1%

6F-21
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%

6F-22
 EAR - Formula

m
 APR 
EAR  1   1
 rate, and
Remember that theAPR is themquoted
m is the number of compounding periods per year

6F-23
 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?

6F-24
 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 = .0539 / 2 = .0265
• FV = 100(1.0265)2 = 105.37
• You have more money in the first account.

6F-25
Future Values with Monthly
Compounding
• 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

6F-26
 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) = 1,095
– PV = 15,000 / (1.00015068493)1095 =
12,718.56

6F-27