2-2

Chapter 2
Principles of
TERM
Corporate Finance
Tenth Edition
Annuity Hàng năm
Perpetuities: Vĩnh viễn
Compound: Ghép
How to Calculate Discount factor: nhân tố chiết khấu
Present Values

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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Topics Covered Present and Future Value

Future Values and Present Values Future Value
Looking for Shortcuts—Perpetuities and Amount to which an
Annuities investment will grow
More Shortcuts—Growing Perpetuities and after earning interest
Annuities Present Value
How Interest Is Paid and Quoted Value today of a
future cash
flow.
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Future Values Future Values

Future Value of $100 = FV FV  $100  (1  r ) t

Example - FV

FV  $100  (1  r ) t 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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Future Values with Compounding Example

1800 What is the future value of $20,000 paid at the
1600 0% end of each of the following 5 years, assuming
1400 5%
10%
your investment returns 8% per year?
1200
FV of $100

15%
1000
Interest Rates
800
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
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Present Value Present Value

Discount Factor = DF = PV of $1
Present Value = PV
DF  1
(1 r ) t

PV = discount factor  C1 Discount Factors can be used to compute the present value of
any cash flow.

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Present Value Present Values with Compounding

 The PV formula has many applications. Given 120

any variables in the equation, you can solve for the Interest Rates
100
remaining variable. Also, you can reverse the prior 0%
5%
example. 80
PV of $100

10%
60 15%

PV  DF2  C2 40

PV  1
(1.07 ) 2
114.49  100 20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
 2-13 2-14

Valuing an Office Building Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 370,000 Step 3: Discount future cash flows
Sale price in Year 1 = C1 = 420,000
C1
PV  (1r )  420, 000
(1 .05 )  400 ,000
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market Step 4: Go ahead if PV of payoff exceeds investment
offer a return of 5%, then
Cost of capital = r = 5% NPV  400 ,000  370 ,000
 30 ,000

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Net Present Value Risk and Present Value

Higher risk projects require a higher rate of
return
NPV = PV - required investment Higher required rates of return cause lower
PVs

C1
NPV = C0  PV of C1  $420,000 at 5%
1 r
420,000
PV   400,000
1  .05
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Risk and Present Value Risk and Net Present Value

PV of C1  $420,000 at 12%
420,000 NPV = PV - required investment
PV   375,000
1  .12

NPV = 375,000 - 370,000

PV of C1  $420,000 at 5%  $5,000
420,000
PV   400,000
1  .05

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Net Present Value Rule Rate of Return Rule

Accept investments that have positive net Accept investments that offer rates of return
present value in excess of their opportunity cost of capital

Example Example
Use the original example. Should we accept the
project given a 10% expected return? In the project listed below, the foregone investment
opportunity is 12%. Should we do the project?

420,000
NPV = -370,000 +  $ 30 , 000 Return 
profit

420,000  370,000
 .135 or 13.5%
1.05 investment 370,000
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Multiple Cash Flows Net Present Values

For multiple periods we have the - $370,000
Discounted Cash Flow (DCF) formula $20,000 $ 420,000

Present Value Year

C1 C2 Ct
PV0    .... 
0 1 2
Year 0
(1  r )1 (1  r ) 2 (1  r ) t -$370,000
20,000/1.12 = $17,900
420,000/1.122 = $334,800

T Total = - $17,300

NPV 0  C 0   Ct
(1 r ) t
t 1

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Short Cuts Short Cuts

Sometimes there are shortcuts that make it Perpetuity - Financial concept in which a cash
very easy to calculate the present value of flow is theoretically received forever.
an asset that pays off in different periods.
These tools allow us to cut through the
calculations quickly. cash flow
Return 
present value
C
r
PV
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Short Cuts Present Values

Perpetuity - Financial concept in which a cash Example
flow is theoretically received forever. What is the present value of $1 billion every year, for all
eternity, if you estimate the perpetual discount rate to be
10%??

cash flow PV  $ 1 b il
 $ 1 0 b illio n
PV of Cash Flow  0 .1 0
discount rate
C
PV0  1
r

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Present Values Short Cuts

Example - continued Annuity - An asset that pays a fixed sum each year for
What if the investment does not start making money for 3 a specified number of years.
years?
Asset Year of Payment Present Value
1 2…..t t+1
Perpetuity (first C
payment in year 1) r

C 1

   $ 7 . 5 1 b illio n
Perpetuity (first payment  
 r  (1  r )
t
in year t + 1)
PV  $ 1 b il
0 .1 0
 1
1 .1 0 3 Annuity from year  C   C  1 
     
t 
1 to year t  r   r  (1  r ) 
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Present Values
Example Example
Tiburon Autos offers you “easy payments” of $5,000 per year, at the end Tiburon Autos offers you “easy 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 of each year for 5 years. If interest rates are 7%, per year, what is the
cost of the car? cost of the car?
5,000 5,000 5,000 5,000 5,000
Year
Present Value 0 1 2 3 4 5
at year 0
5,000 / 1.07  4,673
5,000 / 1.07   4,367
2

5,000 / 1.07   4,081

3

5,000 / 1.07   3,814

4

5,000 / 1.07   3,565

5

Total NPV  20,501

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Present Values Short Cuts

Example
Tiburon Autos offers you “easy payments” of $5,000 per year, at the end
Annuity - An asset that pays a fixed sum each
of each year for 5 years. If interest rates are 7%, per year, what is the year for a specified number of years.
cost of the car?
5,000 5,000 5,000 5,000 5,000
Year
Present Value
1 1 
0 1 2 3 4 5
at year 0
PV of annuity  C    t
 r r 1  r  
5,000 / 1.07  4,673
5,000 / 1.07   4,367
2

5,000 / 1.07   4,081

3

5,000 / 1.07   3,814

4

5,000 / 1.07   3,565

5

Total NPV  20,501

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Annuity Short Cut Annuity Short Cut

Example Example - continued

You agree to lease a car for 4 years at $300 per month. You agree to lease a car for 4 years at $300 per
You are not required to pay any money up front or at the month. You are not required to pay any money up
front or at the end of your agreement. If your
end of your agreement. If your opportunity cost of capital opportunity cost of capital is 0.5% per month,
is 0.5% per month, what is the cost of the lease? what is the cost of the lease?

 1 1 
Lease Cost  300    48 
 .005 .0051  .005 
Cost  $12,774.10

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Annuity Short Cut FV Annuity Short Cut

Future Value of an Annuity – The future value of
Example
an asset that pays a fixed sum each year for a
The state lottery advertises a jackpot prize of $295.7
specified number of years.
million, paid in 25 installments over 25 years of $11.828
million per year, at the end of each year. If interest rates

 1  r t  1
are 5.9% what is the true value of the lottery prize?

 1 
FV of annuity  C   
Lottery Value  11.828   
1
25   r 
 .059 .0591  .059 
Value  $152,600,000
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Annuity Short Cut Constant Growth Perpetuity

Example
What is the future value of $20,000 paid at the end of each C1
of the following 5 years, assuming your investment returns PV 0 
8% per year? rg

 1  .085  1
FV  20,000    g = the annual growth
 .08  rate of the cash flow
 $117,332

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Constant Growth Perpetuity Constant Growth Perpetuity

Example
NOTE: This formula can be What is the present value of $1 billion paid at the end of
used to value a perpetuity at every year in perpetuity, assuming a rate of return of 10%
any point in time. and a constant growth rate of 4%?
C t 1
C PV t 
PV 0  1
rg rg PV0 
1
.10  .04
 $ 16 .667 billion
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Perpetuities Effective Interest Rates

A three-year stream of cash flows that grows at

the rate g is equal to the difference between two Effective Annual Interest Rate (EAR) - Interest
growing perpetuities. rate that is annualized using compound interest.

Annual Percentage Rate (APR) - Interest rate

that is annualized using simple interest.

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Effective Interest Rates Effective Interest Rates

example example
Given a monthly rate of 1%, what is the Effective Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)? Percentage Rate (APR)?

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

APR = .01 x 12 = .12 or 12.00%

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Web Resources Exercise

Click to access web sites 1. What is the present value annuity factor at a discount
Internet connection required rate of 11% for 8 years?
2. What is the present value annuity factor at an interest
www.smartmoney.com rate of 9% for 6 years?
http://finance.yahoo.com
www.in.gov/ifa/files/TollRoadFinancialAnalysis.pdf 3. a.What is the present value of $1000 per year annuity
www.mhhe.com/bma for five years at an interest rate of 12%?
b. What is the present value of $1000 in five years at an
interest rate of 12%?
4. What is the present value of $5000 per year annuity
at a discount rate of 10% for 6 years?

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Exercise Exercise
5. The present value of $500 expected in three 5. Given a quarterly rate of 3%, what is the
years from today at a discount rate of 8% is: Effective Annual Rate(EAR)? What is the
6. If you invest $800 on the bank with 10% of Annual Percentage Rate (APR)?
compound rate. What is your account after 6. Given a semi- annually rate of 6%, what is
four years? the Effective Annual Rate(EAR)? What is the
Annual Percentage Rate (APR)?
7. Given Effective Annual Rate(EAR) of 12%?
What is the Semi- Annual Percentage Rate (S-
APR)?
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Exercises Question 2
1. The present value of $100 expected in two years
2. Present Value is defined as:
from today at a discount rate of 6% is:
A. $116.64 A. Future cash flows discounted to the
B. $108.00 present at an appropriate discount rate
C. $100.00 B. Inverse of future cash flows
D. $89.00 C. Present cash flow compounded into the
future
D. None of the above

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Question 3
3. If the interest rate is 12%, what is the 2-year
discount factor?
A. 0.7972
B. 0.8929
C. 1.2544
D. None of the above