Corporate Finance

Twelfth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan / Joe Smolira (digital co-author)

Chapter 4
Discounted Cash Flow Valuation

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction
or further distribution permitted without the prior written consent of McGraw-Hill Education.
 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

© 2019 McGraw-Hill Education. 4-2

 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?

© 2019 McGraw-Hill Education. 4-3

 4.1 Valuation: The One-Period Case

If you were to invest $10,000 at 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).

© 2019 McGraw-Hill Education. 4-4

 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 (i.e., the value today), and r

is the appropriate interest rate.

© 2019 McGraw-Hill Education. 4-5

 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, 200 
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).

© 2019 McGraw-Hill Education. 4-6

 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

© 2019 McGraw-Hill Education. 4-7

 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?

© 2019 McGraw-Hill Education. 4-8

 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 Net Present Value is
positive, so the investment should be purchased.

© 2019 McGraw-Hill Education. 4-9

 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

© 2019 McGraw-Hill Education. 4-10

 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.

© 2019 McGraw-Hill Education. 4-11

 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   1.40 

5

© 2019 McGraw-Hill Education. 4-12

 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.

© 2019 McGraw-Hill Education. 4-13

Future Value and Compounding – II

© 2019 McGraw-Hill Education. 4-14

 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?

© 2019 McGraw-Hill Education. 4-15

 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   1.10 

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
© 2019 McGraw-Hill Education. 4-16
 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 r 
12
  10  
1  r  101 12

$5, 000

r  101 12  1  1.2115  1  .2115

© 2019 McGraw-Hill Education. 4-17
 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 (CLR TVM) after each
problem
• Other calculators are similar in format
© 2019 McGraw-Hill Education. 4-18
 Multiple Cash Flows - I

Consider an investment that pays $200 one year from

now, with cash flows increasing by $200 per year
through year four. 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?

© 2019 McGraw-Hill Education. 4-19

 Multiple Cash Flows – II

Present Value < Cost → Do Not Purchase

© 2019 McGraw-Hill Education. 4-20

 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

© 2019 McGraw-Hill Education. 4-21
 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 

© 2019 McGraw-Hill Education. 4-22

 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 
 $50   1.06   $70.93
6
FV  $50  1  
 2 

© 2019 McGraw-Hill Education. 4-23

 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 
 $50   1.06   $70.93
6
FV  $50  1  
 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   $70.93
3

© 2019 McGraw-Hill Education. 4-24

 Effective Annual Rates of Interest – II

FV  $50   1  EAR   $70.93

3

$70.93
 1  EAR 
3

$50
13
 $70.93 
EAR     1  .1236
 $50 
So, investing at 12.36 percent compounded annually is the same
as investing at 12 percent compounded semiannually.

© 2019 McGraw-Hill Education. 4-25

 Effective Annual Rates of Interest - III

Find the Effective Annual Rate (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 
   1.1956
12
 1     1    1.015
 m  12 

© 2019 McGraw-Hill Education. 4-26

 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

© 2019 McGraw-Hill Education. 4-27

 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. ex is a key on your calculator.
© 2019 McGraw-Hill Education. 4-28
 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

© 2019 McGraw-Hill Education. 4-29

 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

© 2019 McGraw-Hill Education. 4-30

 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

© 2019 McGraw-Hill Education. 4-31

 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
© 2019 McGraw-Hill Education. 4-32
 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
© 2019 McGraw-Hill Education. 4-33
 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 1 
PV  1  
r   1  r  T 

© 2019 McGraw-Hill Education. 4-34

 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 
PV  1  36 
 $12,954.59
.07 12   1  .07 12  

© 2019 McGraw-Hill Education. 4-35

 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        $323.97
 1.09   1.09   1.09   1.09   1.09 
t 1 2 3 4
t 1

© 2019 McGraw-Hill Education. 4-36

 Growing Annuity

A growing stream of cash flows with a fixed maturity

C   1 g  C   1 g 
T 1
C
PV     
 1 r   1 r 
2
1 r
T

C   1 g 
T

PV  1    
r  g    1  r   
 
© 2019 McGraw-Hill Education. 4-37
 Growing Annuity: Example I

A defined-benefit retirement plan offers to pay $20,000

per year for 40 years and increase the annual payment
by 3 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  

© 2019 McGraw-Hill Education. 4-38

 Growing Annuity: Example II

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 percent each
year. What is the present value of the estimated income stream
over the first five years if the discount rate is 12 percent?

Access the text alternative for slide images

© 2019 McGraw-Hill Education. 4-39
 4.5 Loan Amortization

Pure discount loans are the simplest form of loan. The

borrower receives money today and repays a single
lump sum (principal and interest) at a future time.
Interest-only loans require an interest payment each
period, with full principal due at maturity.
Amortized loans require repayment of principal over
time, in addition to required interest.

© 2019 McGraw-Hill Education. 4-40

 Pure Discount Loans

Treasury bills are excellent examples of pure discount

loans. The principal amount is repaid at some future
date, without any periodic interest payments.
If a T-bill promises to repay $10,000 in 12 months and
the market interest rate is 7 percent, how much will the
bill sell for in the market?
PV  10, 000 1.07  9,345.79

© 2019 McGraw-Hill Education. 4-41

 Interest-Only Loan

Consider a five-year, interest-only loan with a 7 percent

interest rate. The principal amount is $10,000. Interest is
paid annually.
• What would the stream of cash flows be?
• Years 1−4: Interest payments of .07(10,000) = 700
• Year 5: Interest + principal = 10,700
This cash flow stream is similar to the cash flows on
corporate bonds, and we will talk about them in greater
detail later.

© 2019 McGraw-Hill Education. 4-42

 Amortized Loan with Fixed Principal
Payment
Consider a $50,000, 10 year loan at 8 percent interest.
The loan agreement requires the firm to pay $5,000 in
principal each year plus interest for that year.
Beginning Principal
Year Total Payment Interest Paid Ending Balance
Balance Paid
1 $50,000 $50,001 $4,000 $5,000 $45,000
2 $45,000 $45,002 $3,600 $5,000 $40,000
3 $40,000 $40,003 $3,200 $5,000 $35,000
4 $35,000 $35,004 $2,800 $5,000 $30,000
5 $30,000 $30,005 $2,400 $5,000 $25,000
6 $25,000 $25,006 $2,000 $5,000 $20,000
7 $20,000 $20,007 $1,600 $5,000 $15,000
8 $15,000 $15,008 $1,200 $5,000 $10,000
9 $10,000 $10,009 $800 $5,000 $5,000
10 $5,000 $5,010 $400 $5,000 $0

© 2019 McGraw-Hill Education. 4-43

 Amortized Loan with Fixed Payment

Each payment covers the interest expense plus reduces

principal
Consider a four-year loan with annual payments. The interest
rate is 8 percent, and the principal amount is $5,000.
• What is the annual payment?
• 4N
• 8I∕Y
• 5,000 PV
• CPT PMT = −1,509.60
Beginning Interest Principal Ending
Year Total Payment
Balance Paid Paid Balance
1 $ 5,000 $ 1,509.60 $ 400.00 $ 1,109.60 $ 3,890.40
2 $ 3,890.40 $ 1,509.60 $ 311.23 $ 1,198.37 $ 2,692.03
3 $ 2,692.03 $ 1,509.60 $ 215.36 $ 1,294.24 $ 1,397.79
4 $ 1,397.79 $ 1,509.60 $ 111.82 $ 1,397.78 $ 0.02 (rounding)

© 2019 McGraw-Hill Education. 4-44

 4.6 What Is a Firm Worth?

Conceptually, a firm should be worth the present value

of the firm’s cash flows.
The tricky part is determining the size, timing, and risk
of those cash flows.

© 2019 McGraw-Hill Education. 4-45

 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 Net Present Value of an investment?
What is an EAR, and how is it computed?
What is a perpetuity? An annuity?

© 2019 McGraw-Hill Education. 4-46

 End of Main Content

© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
further distribution permitted without the prior written consent of McGraw-Hill Education. 4-47