Because learning changes everything.

Corporate Finance
Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 4

Discounted Cash Flow Valuation

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 Key Concepts and Skills
• 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.

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 Chapter Outline
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?

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 4.1 Valuation: The One-Period Case
If you were to invest $10,000 at a rate of 12 percent interest
for one year, your investment would grow to $11,200.

$1,200 would be interest ($10,000 × .12)

$10,000 is the principal repayment ($10,000 × 1)
$11,200 is the total due. It can be calculated as:
$11,200 = $10,000 × (1.12)

The total amount due at the end of the investment is

called the Future Value (FV).

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 One-Period Case Future Value
In the one-period case, the formula for FV can be
written as:
FV = PV × (1 + r)

Where PV is present value (that is, the value today),

and r is the appropriate interest rate.

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 Present Value - I
If you were to be promised $11,424 due in one year when interest
rates are 12 percent, your investment would be worth $10,200 in
today’s dollars.

$11, 424
$10, 220 
1.12

The amount that a borrower would need to set aside today to be

able to meet the promised payment of $11,424 in one year is the
Present Value (PV).
Note that $11,424 = $10,200 × (1.12).

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 Present Value – II
In the one-period case, the formula for PV can be
written as:

C1
PV 
1 r

Where C1 is cash flow at Date 1, and r is the appropriate

interest rate. We could also write the formula as:
PV = FV1/1 + r

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 Net Present Value – I
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
percent. Should you buy?

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 Net Present Value – II
$10, 000
NPV  $9,500 
1.05
NPV  $9,500  $9,523.81

NPV $23.81

The present value of the cash inflow is greater than the cost.
In other words, the NPV is positive, so the investment should
be purchased.

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 Net Present Value – III
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

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 4.2 The Multiperiod Case
The general formula for the future value of an investment
over many periods can be written as:

FV PV 1  r 
t

Where
PV is present value,
r is the appropriate interest rate, and
t is the number of periods over which the cash is invested.

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 Multiperiod Case Future Value
Suppose a stock currently pays a dividend of $1.10, which is
expected to grow at 40 percent per year for the next five years.
What will the dividend be in five years?

FV PV 1  r 
t

$5.92 $1.10 1.405

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 Future Value and Compounding - I
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.

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 Future Value and Compounding – II

Access the text alternative for slide images.

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 Present Value and Discounting
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
percent?

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 Finding the Number of Periods
If we deposit $5,000 today in an account paying 10 percent, how
long does it take to grow to $10,000?

$10,000 $5,000 1.10T

$10,000
T
1.10  2
$5,000

ln 1.10  ln 2 
T

ln 2  .6931
T  7.27 years
ln 1.10  .0953

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 What Rate Is Enough?
Assume the total cost of a college education will be $50,000 when
your child enters college in 12 years. You have $5,000 to invest
today. What rate of interest must you earn on your investment to
cover the cost of your child’s education?
About 21.15%.

$50,000 $5,000 1  r 

12

$50,000 1
1  r 
12
 10 1  r  10 12
$5,000

r 101 12  1 1.2115  1 .2115

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 Calculator Keys
Texas Instruments BA-II Plus
FV = future value.
PV = present value.
I/Y = periodic interest rate.
• P/Y must equal 1 for the I/Y to be the periodic rate.
• Interest is entered as a percent, not a decimal.

N = number of periods.

Remember to clear the registers (C LRTVM) after each problem.

Other calculators are similar in format.

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 Multiple Cash Flows - I
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 percent, what is the present value of
this stream of cash flows?
If the issuer offers this investment for $1,500, should you
purchase it?

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 Multiple Cash Flows – II

Present Value < Cost → Do Not Purchase

Access the text alternative for slide images.

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 Valuing “Lumpy” Cash Flows
First, set your calculator to one payment per year.
Then, use the cash flow menu:

Access the text alternative for slide images.

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 4.3 Compounding Periods
Compounding an investment m times a year for T years
provides for future value of wealth:

m
 1 r 
FV C0  
 m 

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 Compounding Periods
For example, if you invest $1,000 for one year at 10
percent interest compounded semiannually, your
investment will grow to:

23
 .12 
FV $50  1   $50 1.066 $70.93
 2 

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 Effective Annual Rates of Interest – I
A reasonable question to ask in the above example is “what is the
effective annual rate of interest on that investment?”

23
 .12 
FV $50  1   $50 1.066 $70.93
 2 

The effective annual rate (EAR) of interest is the annual rate that
would give us the same end-of-investment wealth after 3 years:

$50 (1 + EAR)3 $70.93

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 Effective Annual Rates of Interest – II

FV = $50 (1 + EAR)3 $70.93

$70.93
1  EAR 
3

$50

1
 $70.93  3
EAR    1 .1236
 $50 

So, investing at 12.36 percent compounded annually is the same

as investing at 12 percent compounded semiannually.

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 Effective Annual Rates of Interest - III
Find the EAR of an 18 percent APR loan that is compounded
monthly.
What we have is a loan with a monthly interest rate of 1½ percent.
This is equivalent to a loan with an annual interest rate of 19.56
percent.

m 12
 r  .18  12
 1    1   1.015 1.1956
 m  12 

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 EAR on a Financial Calculator
Texas Instruments BAII Plus

Keys description:

 2nd  ICONV  Opens interest rate conversion

menu
  C Y 12  ENTER  Sets 12 payments per year

    NOM 18  ENTER  Sets 18 APR

    EFF  CPT  19.56

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 Continuous Compounding
The general formula for the future value of an investment compounded
continuously over many periods can be written as:

FV C0 e rt

Where
C0 is the initial investment,
r is the APR,
t is the number of years, and
e is a transcendental number approximately equal to
2.718.e x is a key on your calculator.

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 4.4 Simplifications
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.

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 Perpetuity
A constant stream of cash flows that lasts forever

C C C
PV     
1  r  1  r  1  r 
2 3

C
PV 
r

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 Perpetuity: Example
What is the value of a British consol that promises to pay £15
every year for ever?
The interest rate is 10 percent.

£15
PV  £150
.10

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 Growing Perpetuity
A growing stream of cash flows that lasts forever

C 1  g  C 1  g 
2
C
PV    
1  r  1  r  2
1  r 
3

C
PV 
r g
Access the text alternative for slide images.
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 Growing Perpetuity: Example
The expected dividend next year is $1.30, and dividends are
expected to grow at 5 percent forever.
If the discount rate is 10 percent, what is the value of this
promised dividend stream?

$1.30
PV  $26.00
.10  .05

Access the text alternative for slide images.

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 Annuity
A constant stream of cash flows with a fixed maturity

C C C C
PV    
1  r  1  r  1  r 
2 3
1  r 
T

C C 
PV   1  
r  1  r T 

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 Annuity: Example I
If you can afford a $400 monthly car payment, how much car can
you afford if interest rates are 7 percent on 36-month loans?

 
 
$400  1  $12,954.59
PV  1
.07   .07
36
 
12  1  
 12  

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 Annuity: Example II
What is the present value of a four-year annuity of $100 per year
that makes its first payment two years from today if the discount
rate is 9 percent?
4
$100 $100 $100 $100 $100
PV1  t
 1
 2
 3
 4
$323.97
t 1 1.09 1.09 1.09 1.09 1.09

Access the text alternative for slide images.

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 Quick Quiz
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 NPV of an investment?
What is an EAR, and how is it computed?
What is a perpetuity? An annuity?

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