Chapter 2

HOW TO CALCULATE
PRESENT VALUES

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Edition
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
2-1 FUTURE VALUES AND PRESENT VALUES

• Calculating Future Values

• Future Value
• Amount to which investment will grow
after earning interest
• Present Value
• Value today of future cash flow

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2-1 FUTURE VALUES AND PRESENT VALUES

• Future Value of $100 =

FV = $100  (1 + r) t

• Example: FV

• What is the future value of $100 if interest is

compounded annually at a rate of 7% for two
years?
FV = $100  (1.07)  (1.07) = $114.49
FV = $100  (1 + .07) 2 = $114.49
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FIGURE 2.1 FUTURE VALUES WITH
COMPOUNDING

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2-1 FUTURE VALUES AND PRESENT VALUES

• Discount factor = DF = PV of $1

• Discount factors can be used to compute

present value of any cash flow

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2-1 FUTURE VALUES AND PRESENT VALUES

• Given any variables in the equation, one

can solve for the remaining variable
• Prior example can be reversed

PV = DF2  C2
PV = (1+.107)2 114.49 = 100

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FIGURE 2.2 PRESENT VALUES WITH
COMPOUNDING

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2-1 FUTURE VALUES AND PRESENT VALUES

• Valuing an Office Building

• Step 1: Forecast Cash Flows
• Cost of building = C0 = $700,000
• Sale price in year 1 = C1 = $800,000
• Step 2: Estimate Opportunity Cost of
Capital
• If equally risky investments in the capital
market offer a return of 7%, then cost of
capital = r = 7%
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2-1 FUTURE VALUES AND PRESENT VALUES

• Valuing an Office Building

• Step 3: Discount future cash flows

PV = C1
(1+r ) = $800, 000
(1+.07 ) = $747 ,664
• Step 4: Go ahead if PV of payoff exceeds
investment
NPV = $747,664 − $700,000
= $47,664

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2-1 FUTURE VALUES AND PRESENT VALUES

• Net Present Value

NPV = PV − required investment

C1
NPV = C0 +
1+ r

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2-1 FUTURE VALUES AND PRESENT VALUES

• Risk and Present Value

• Higher risk projects require a higher rate of
return
• Higher required rates of return cause lower PVs

PV of C1 = $800,000 at 7%
$800,000
PV = = $747,664
1 + .07

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2-1 FUTURE VALUES AND PRESENT VALUES

• Risk and Net Present Value

NPV = PV − required investment

NPV = $747,664 − $700,000
= $47,664

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2-1 FUTURE VALUES AND PRESENT VALUES

• Net Present Value Rule

• Accept investments that have positive net
present value
• Using the original example: Should one accept
the project given a 10% expected return?

$800,000
NPV = −$700,000 + = $27,273
1.1

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2-1 FUTURE VALUES AND PRESENT VALUES

• Rate of Return Rule

• Accept investments that offer rates of return in
excess of their opportunity cost of capital
• In the project listed below, the opportunity cost
of capital is 12%. Is the project a wise
investment?
profit $800,000 − $700,000
Return = = = .143, or 14.3%
investment $700,000

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2-1 FUTURE VALUES AND PRESENT VALUES

• Multiple Cash Flows

• Discounted Cash Flow (DCF) formula:

PV0 = C1
(1+ r )1 + (1+ r ) 2 + .... + (1+ r )t
C2 Ct

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FIGURE 2.5 NET PRESENT VALUES

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2-2 PERPETUITIES AND ANNUITIES

• Perpetuity
• Financial concept in which cash flow is
theoretically received forever

cash flow
Return =
present value
C
r=
PV
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2-2 PERPETUITIES AND ANNUITIES

• Perpetuity

cash flow
PV of cash flow =
discount rate
C1
PV0 =
r

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2-2 PERPETUITIES AND ANNUITIES

• Present Value of Perpetuities

• What is the present value of $1 billion
every year, for eternity, if the perpetual
discount rate is 10%?

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2-2 PERPETUITIES AND ANNUITIES

• Present Value of Perpetuities

• What if the investment does not start
making money for 3 years?

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2-2 PERPETUITIES AND ANNUITIES

• Annuity
• Asset that pays fixed sum each year for
specified number of years
Asset Year of Payment Present Value
1 2…..t t+1
Perpetuity (first
payment in year 1)

Perpetuity (first
payment in year t + 1)

Annuity from  C   C  1 
  −   
t 
year 1 to year t  r   r  (1 + r ) 

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2-2 PERPETUITIES AND ANNUITIES
• Example: Tiburon Autos offers payments of $5,000 per year,
at the end of each year for 5 years. If interest rates are 7%,
per year, what is the cost of the car?

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2-2 PERPETUITIES AND ANNUITIES

1 1 
PV of annuity = C   − t 
 r r (1 + r ) 

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2-2 PERPETUITIES AND ANNUITIES

• Annuity
• Example: The state lottery advertises a jackpot
prize of $365 million, paid in 30 yearly
installments of $12.167 million, at the end of
each year. Find the true value of the lottery
prize if interest rates are 6%.
 1 1 
Lottery Value = 12.167   − 30 
 .06 ( )
.06 1 + .06 
Value = $167,500,000

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2-2 PERPETUITIES AND ANNUITIES

• Future Value of an Annuity

 (1 + r ) − 1
t
FV of annuity = C   
 r 

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2-2 PERPETUITIES AND ANNUITIES

• Future Value of an Annuity

• What is the future value of $20,000 paid at the
end of each of the following 5 years, assuming
investment returns of 8% per year?

 (1 + .08)5 − 1
FV = 20,000   
 .08 
= $117,332

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2-3 GROWING PERPETUITIES AND ANNUITIES

• Constant Growth Perpetuity

C1 g = the annual growth
PV0 =
r−g rate of the cash flow

• This formula can be used to value a perpetuity

at any point in time

Ct +1
PVt =
r−g

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2-3 GROWING PERPETUITIES AND ANNUITIES

• Constant Growth Perpetuity

• What is the present value of $1 billion paid at
the end of every year in perpetuity, assuming a
rate of return of 10% and constant growth rate
of 4%?

1
PV0 =
.10 − .04
= $16.667 billion

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2-3 GROWING PERPETUITIES AND ANNUITIES

• Growing Annuities
• Golf club membership is $5,000 for 1 year, or
$12,750 for three years. Find the better deal
given payment due at the end of the year and
6% expected annual price increase, discount
rate 10%.

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2-4 HOW INTEREST IS PAID AND QUOTED

• Effective Annual Interest Rate (EAR)

• Interest rate annualized using compound
interest
• Annual Percentage Rate (APR)
• Interest rate annualized using simple
interest

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2-4 HOW INTEREST IS PAID AND OUTLAID

• Given a monthly rate of 1%, what is the

(EAR)? What is the (APR)?

EAR = (1 + .01)12 − 1 = r
EAR = (1 + .01)12 − 1 = .1268, or 12.68%

APR = .01  12 = .12, or 12.00%

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QUESTIONS
1) If the annual interest rate is 12.00%, what is the two-year
discount factor?
A. 0.7972
B. 0.8929
C. 1.2544
D. 0.8065
ANS: A
DF2 = 1/(1.12^2) = 0.7972.

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QUESTIONS
2) The rate of return is also called the:
I) discount rate; II) hurdle rate; III) opportunity cost of capital
A. I only.
B. I and II only.
C. I, II, and III.
D. I and III only
ANS: C

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QUESTIONS
3) If the one-year discount factor is 0.8333, what is the discount
rate (interest rate) per year?
A. 10%
B. 20%
C. 30%
D. 40%
ANS: B
DF = 1/(1 + r)^1 = 0.8333; 1 + r = 1/0.8333; r = 20%

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QUESTIONS
4) If the one-year discount factor is 0.90, what is the present
value of $120 expected one year from today?
A. $100
B. $96
C. $108
D. $133
ANS: C
PV = (120)(0.90) = 108.

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QUESTIONS
5) An initial investment of $400,000 is expected to produce an
end-of-year cash flow of $480,000. What is the NPV of the
project at a discount rate of 20%?
A. $176,000
B. $80,000
C. $0 (zero)
D. $64,000
ANS: C
NPV = -400,000 + (480,000/1.2) = 0.

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QUESTIONS
6) What is the present value of the following cash flows at a discount rate of
9%?

A. $372,431.81
B. $450,000.00
C. $405,950.68
D. $412,844.04
ANS: A
PV = (100,000/1.09) + (150,000/(1.09^2)) + 200,000/(1.09^3) = 372,431.81.

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QUESTIONS
7) Which of the following statements regarding the NPV rule
and the rate of return rule is false?
A. Accept a project if its NPV > 0.
B. Reject a project if the NPV < 0.
C. Accept a project if its rate of return > 0.
D. Accept a project if its rate of return > opportunity cost of
capital.
ANS: C

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QUESTIONS
8) An initial investment of $500 produces a cash flow of $550
one year from today. Calculate the rate of return on the project.
A. 10%
B. 15%
C. 20%
D. 25%
ANS: A
Rate of return = (550 - 500)/500 = 10%

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QUESTIONS
9) At an interest rate of 10%, which of the following sequences of cash flows
should you prefer?

A. option A
B. option B
C. option C
D. option D
PV(A) = 777.61; PV(B) = 714.50; PV(C) = 746.05; A is preferred.

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QUESTIONS
10) Which of the following statements regarding the net present
value rule and the rate of return rule is false?
A. Accept a project if NPV > cost of investment.
B. Accept a project if NPV is positive.
C. Accept a project if return on investment exceeds the rate of
return on an equivalent risk investment in the financial market.
D. Reject a project if NPV is negative.
ANS: A

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QUESTIONS
11) You would like to have enough money saved after your retirement such
that you and your heirs can receive $100,000 per year in perpetuity. How
much would you need to have saved at the time of your retirement in order to
achieve this goal? (Assume that the perpetuity payments start one year after
the date of your retirement. The annual interest rate is 12.5%.)
A. $1,000,000
B. $10,000,000
C. $800,000
D. $1,125,000
ANS: C
PV = (100,000/0.125) = 800,000.

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QUESTIONS
12) You would like to have enough money saved to receive a $50,000 per
year perpetuity after retirement. How much would you need to have saved in
your retirement fund to achieve this goal? (Assume that the perpetuity
payments start on the day of your retirement. The annual interest rate is 8%.)
A. $1,000,000
B. $675,000
C. $625,000
D. $500,000
ANS: B
PV = 50,000 + 50,000/0.08 = $675,000

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QUESTIONS
13) What is the present value of a $1,000 per year annuity for
five years at an interest rate of 12%?
A. $6,352.85
B. $3,604.78
C. $567.43
D. $2,743.28
ANS: B
PV annuity factor = [(1/0.12) - (1/((0.12)(1.12^ 5)))] × 1000 =
3,604.78.

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QUESTIONS
14) If you invest $100 at 12% APR for three years, how much
would you have at the end of three years using simple interest
and compound interest?
A. $136.00, $140.49
B. $140.49, $187.13
C. $240.18, $140.49
D. $187.13, $136.00
ANS: A
FVs = 100 + (100 x 0.12 × 3) = $136.
FVc = 100 × (1.12^3) = $140.49.

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QUESTIONS
15) You just inherited a trust that will pay you $100,000 per year
in perpetuity. However, the first payment will not occur for
exactly four more years. Assuming an 8% annual interest rate,
what is the value of this trust?
A. $918,787
B. $992,290
C. $1,000,000
D. $1,250,000
ANS: B
PV (@ t = 3) = 100,000/0.08 = $1,250,000; PV (@ t = 0) =
1,250,000/(1.08)^3 = $992,290.
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