Lecture 2

Discounted Cash Flow Valuation

Chapter Outline
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
 4.1 The One-Period Case
 If you were to invest $10,000 at 5-percent interest for
one year, your investment would grow to $10,500.

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:
$10,500 = $10,000×(1.05)
 The total amount due at the end of the investment is
call the Future Value (FV).
 Future Value
In the one-period case, the formula for FV can
be written as:
FV = C0×(1 + r)

Where C0 is cash flow today (time zero), and

r is the appropriate interest rate.

Q: Given FV and r, how to calculate C0?

Present Value
 If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s dollars.
$10,000
$9,523.81 
1.05
• The amount that a borrower would need to set
aside today to be able to meet the promised
payment of $10,000 in one year is called the
Present Value (PV).
Note that $10,000 = $9,523.81×(1.05).
 Present Value
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.
4.2 The Multiperiod Case
 The general formula for the future value of an
investment over many periods can be written as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.
 Future Value
Suppose you deposit $1.10 today. The
interest rate is 40% per year. How much you
can withdraw at the end of the fifth year?
(Exact ans = 5.9160)

FV = C0×(1 + r)T

$5.92 = $1.10×(1.40)5
 Future Value and Compounding
Notice that the amount in year five, $5.92, is
considerably higher than the sum of the
principal amount plus 5*(interests in year 1):

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

Future Value and Compounding
$1.10  (1.40) 5

$1.10  (1.40) 4
$1.10  (1.40) 3
$1.10  (1.40) 2
$1.10  (1.40)

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5
 Present Value and Discounting
Ans = 9943.53
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%?
PV $20,000

0 1 2 3 4 5
$20,000
$9,943.53 
(1.15) 5
How Long is the Wait?
If we deposit $5,000 today in an account paying 10%,
how long does it take to grow to $10,000?
FV  C0  (1  r )T $10,000  $5,000  (1.10)T
$10,000
(1.10) 
T
2
$5,000
ln(1.10)  ln(2)
T

ln(2) 0.6931
T   7.27 years
ln(1.10) 0.0953
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? (Ans 0.21152)

About 21.15%.
FV  C0  (1  r ) T
$50,000  $5,000  (1  r ) 12

$50,000 (1  r )  101 12
(1  r ) 
12
 10
$5,000

r  10 1 12
 1  1.2115  1  .2115
Multiple Cash Flows
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%, what is the present
value of this stream of cash flows?
(Ans=1432.931591)
If the issuer offers this investment for
$1,500, should you purchase it?
 Multiple Cash Flows
0 1 2 3 4

200 400 600 800

178.57
318.88
427.07
508.41
1,432.93 Present Value < Cost → Do Not Purchase
 4.3 Compounding Periods
Compounding an investment m times a year for
T years provides for future value of wealth:
mT
 r
FV  C0  1  
 m
 Compounding Periods
 For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to?

0 1 2 3

$50 ??
 Compounding Periods
Ans: $50*(1+12%)^3=$70.25 (wrong)
It is wrong because the one year interest rate
actually is not 12%. 12% is a quoted rate. We
cannot apply it directly in the calculation.
12% compounded semiannually = the interest rate
for a 6 months period is 12%/2
Correct answer: 23
 .12 
FV  $50  1    $ 50  (1 . 06) 6
 $70.93
 2 
 Compounding Periods
IPO margin example: HSBC charge 5%
compounded daily. If you borrow $100,000 to
subscribe IPO issued by firm A, how much
you need to pay 10 days later?
5% compounded daily is equivalent to: Daily
interest rate=5%/365=0.0137%
FV=$100,000*(1+0.0137%)^10=$100,137
How about if you borrow it for 365 days,
instead of 10 days?
 Compounding Periods
FV=$100,000*(1+0.0137%)^365=$105,127
The actual one year interest rate is
5127/100,000=5.127%
5.127% here is called Effective Annual Rate of
Interest (EAR)
It can also be calculated with (1+5%/365)^365-
1=5.127%
5% here is called Annual Percentage Rate (APR).
It is meaningless if we do not know how it is
compounded. In this example, we know it is
compounded daily.
Effective Annual Rates of Interest
 In our first example, if 12% is not the
“actual” one year interest rate, what rate it
should be?
$1 will grow to how much one year later, if the
interest rate is 12% compounded semiannually?
$1*(1+12%/2)^2=$1.1236
It should be 12.36%!
So, investing at 12.36% compounded annually is
the same as investing at 12% compounded semi-
annually.
 Effective Annual Rates of Interest
Find the Effective Annual Rate (EAR) of an 18%
APR loan that is compounded monthly. (Ans =
0.195618171)
What we have is a loan with a monthly interest rate
of 1½% (18%/12).
This is equivalent to a loan with an annual interest
rate of 19.56%.
m 12
 APR   .18 
EAR  1    1  1    1  (1.015)  1  0.1956
12

 m   12 
 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
 Perpetuity
A constant stream of cash flows that lasts forever

C C C
…
0 1 2 3
C C C
PV    
(1  r ) (1  r ) (1  r )
2 3

C
PV 
r
 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 £15 £15

…
0 1 2 3
15
PV   150
.10
 Growing Perpetuity
A growing stream of cash flows that lasts forever

C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2
(1  r ) 3

C
PV 
rg
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? (Ans = 26)

$1.30 $1.30×(1.05) $1.30 ×(1.05)2

…
0 1 2 3
$1.30
PV   $26.00
.10  .05
Annuity
A constant stream of cash flows with a fixed maturity

C C C C

0 1 2 3 T
C C C C
PV    
(1  r ) (1  r ) (1  r )
2 3
(1  r ) T

C 1 
PV  1  T 
r  (1  r ) 
Assume monthly compounding
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on 36-
month loans? (Ans = $12,954.59)

$400 $400 $400 $400


0 1 2 3 36
$400  1 
PV  1  36 
 $12,954.59
.07 / 12  (1  .07 12) 
 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%? (Ans = $323.97 => 297.222)

4
$100 $100 $100 $100 $100
PV1        $323.97
  t 1
t 1 2 3
(1.09) (1.09) (1.09) (1.09) (1.09) 4

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
 Growing Annuity
A growing stream of cash flows with a fixed maturity

C C×(1+g) C ×(1+g)2 C×(1+g)T-1


0 1 2 3 T
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 )  
 
Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000 per
year for 40 years and increase the annual payment by 3% each
year. What is the present value at retirement if the discount rate
is 10%? (Ans = 265121.5741)

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40
$20,000   1.03  
40

PV  1      $265,121.57
.10  .03   1.10  
 Growing Annuity: Example
You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%? (Ans
= 34706.26185) $8,500  (1.07) 2  $8,500  (1.07) 4 
$8,500  (1.07)  $8,500  (1.07)3 
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

0 1 2 3 4 5
$34,706.26