Ch 6.
Discounted cash flow
valuation
1. FV and PV with multiple cash flows
1) FV with multiple cash flows: Two methods
(1) Rolling over FV year by year
(2) FV=FV1+FV2+FV3….
Ex) Deposit $100 every year for 3 yrs. And 10%
interest rate. FV?
2) PV with multiple cash flows: Two
method
(1) Rolling back year by year
(2) PV=PV1+PV2+…..
Ex) You are supposed to need $1000 in one year
and $2000 in the second year. If you can
earn 9% on your money, how much you have
to put up today?
2. Annuities and Perpetuities
1) Def of Annuity:
Constant cash flows for a fixed period of time
Ex) car loan
Ex) Assets with promised to pay $500 at the end
of the each of the next three years. What is
the price of the asset now if a discount rate
is 10%?
Answer:
500/(1.1)+500/(1.1^2)+500/(1.1^3)= 1243.43
2) Formula for Annuity Present Value
C [1 1 /(1 k ) t ]
PV
k
C C C
PV 2
.....
(1 k ) (1 k ) (1 k ) t
C C C
PV (1 k ) C 2
.....
(1 k ) (1 k ) (1 k ) t 1
C
PV PV (1 k ) t
C
(1 k )
1
PV ( k ) C[ t
1]
(1 k )
1
C[1 t
]
(1 k )
Therefore PV
k
Ex) You stop by a car dealer shop and find a really
good car. The sticker price of the car is $15000.
But you don’t have money now. So, want
installment payment over 4 yrs. Over
conversation, the dealer suggests $632 per
month for 48 month at 1% per month.
How much is going to be your PV of total
installments?
2-2) Finding C
Ex) You stop by a car dealer shop and find a
really good car. The sticker price of the car is
$15000. But you don’t have money now. So, if
you want installment payment over 4 yrs, how
much you have to pay monthly? (Here interest
rate is 12%)
2-3) Finding rate
Ex) an insurance company offers to pay you
$1000 per year for 10 years if you pay $6710
up front. What rate is used in this annuity?
3) Def of perpetuities:
An annuity in which the cash flow continues
forever
4) Formula for PV of perpetuities
PV=C/k
Ex) Preferred stock – promised fixed dividend every
period forever.
A company want to sell preferred stock at $100 per
share. How much of dividend it has to pay. Currently
the similar preferred stock is sold at $40 with $1
dividend.
i) Calculate r:
R= 1/40 = 0.025
ii) Calculate C:
100 = C/0.025. Then, C=2.5
5) FV for Annuities
t
FV C [(1 k ) 1] / k
2 t 1
FV C C (1 k ) C (1 k ) ...... C (1 k )
FV (1 k ) C (1 k ) C (1 k ) 2 C (1 k )3 ..... C (1 k )t
FV FV (1 k ) C C (1 k )t
t
FV (k ) C[1 (1 k ) ]
C[(1 k )t 1]
FV
k
Ex) $2000 annuity for 30 years and k= 0.08. What is the
annuity future value?
6) Annuities due
Def: annuity for which the cash flows occur at the beginning
of the period
Annuity due value =
ordinary annuity value * (1+k)
7) Uneven Cash Flows;
• Summing PV and FV of each cash flows
• Using the cash flow patterns to apply formula
8) Growing annuities: payment growth by g%.
1 g t
1[ ]
PV C [ 1 k ]
kg
• E.g) lottery payout over a 20 year period. The
first payment, made one from now, will be
$200,000. Every year thereafter, the payment
will grow by 5% so on during 20 years.
Discount rate is 11%.
• PV = 200000 * (1-(1.05/1.11)^20)/(0.11-0.05)
• = 2236337.06
9) Growing perpetuity: payment grows by g%
forever.
PV C /( k g )
3. Rate
Q1. 10% compounded semi-annually is the same as 10%
per year in compounding?
No! here, 10% is APR, (annual percentage rate) and
actually, 10.25% (=(1+0.05)*(1+0.05)-1) is the effective
annual rate.
To compare to other rates, we need to convert APR into
the effective rates
3-1) APRs (Annual Percentage Rate)
Def: interest rate charged per period (periodic rate)
multiplied by the number of periods per year
APR =EAR?
No!!!!
So, APR is a quoted rate and need to be converted to
the EAR
EAR(Effective Annual Rate)
[1 (APR/m)]m 1
unlimited interest calculatio n
EAR e k 1
e 2.71828
Ex)
One credit card company selling a card by tele-
marketing. The company said the card will
benefit its cardholders with semi-annual
15%APRs, compared to the other credit card
with 16% EAR.
Do you agree or not?
6. Loan types and Amortized loan
1) Pure discount loan:
• Receive money today and repay a single lump sum in future
• What is the price of loan that you will pay $25,000 in 5 years? A
lender wants to apply 12% interest rate.
• 14,186 = 25000/(1.12)^5
2) Interest only loan:
• Pay interest each period and repay the entire principal at some
point in the future
A three year, 10% interest only loan of $1000.
A borrower has to pay $100 at the end of first
and second year. At the end of third year, he or
she has to pay $100 and $1000.
3) Amortized loan:
Repay parts of the loan amount over time
Borrow $5000 for 5 years. An interest rate is 9%.
Annual payment happens.
3-1) constant principal payment
Year Begin Pay Interest Principa End
paid l
1 5000 1450 450 1000 4000
2 4000 1360 360 1000 3000
3 3000 1270 270 1000 2000
4 2000 1180 180 1000 1000
5 1000 1090 90 1000 0
total 6350 1350 5000
3-2. Fixed payment
• 5000 = c*[1-1/(1+0.09)^5]/0.09
• C=1285.46
