CHAPTER 6

D I S C O U N T E D C A S H F L O W VA L U AT I O N
(FORMULAS)

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 KEY CONCEPTS AND SKILLS

• Determine the future and present value of investments with

multiple cash flows

• Explain how loan payments are calculated and how to find the
interest rate on a loan

• Describe how loans are amortized or paid off

• Show how interest rates are quoted (and misquoted)

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 CHAPTER OUTLINE

• Future and Present Values of Multiple Cash Flows

• Valuing Level Cash Flows: Annuities and Perpetuities

• Comparing Rates: The Effect of Compounding

• Loan Types and Loan Amortization

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 MULTIPLE CASH FLOWS – FV
(EXAMPLE 6.1)
• You think you will be able to deposit $4,000 at the end of
each of the next three years in a bank account paying 8
percent interest.
• You currently have $7,000 in the account.
• How much will you have in three years?
• How much will you have in four years?

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 MULTIPLE CASH FLOWS – FV
(EXAMPLE 6.1, CTD.)
• Find the value at year 3 of each cash flow and add them
together.
 Today (year 0): FV = 7000(1.08)3 = 8,817.98
 Year 1: FV = 4,000(1.08)2 = 4,665.60
 Year 2: FV = 4,000(1.08) = 4,320
 Year 3: value = 4,000
 Total value in 3 years = 8,817.98 + 4,665.60 + 4,320 +
4,000 = 21,803.58

• Value at year 4 = 21,803.58(1.08) = 23,547.87

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 MULTIPLE CASH FLOWS – FV
EXAMPLE 2
• Suppose you invest $500 in a mutual fund today and $600 in
one year.
• If the fund pays 9% annually, how much will you have in two years?

 FV = 500(1.09)2 + 600(1.09) = 1,248.05

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 MULTIPLE CASH FLOWS –
EXAMPLE 2 (CTD.)
• How much will you have in 5 years if you make no further
deposits?

• First way:
 FV = 500(1.09)5 + 600(1.09)4 = 1,616.26

• Second way – use value at year 2:

 FV = 1,248.05(1.09)3 = 1,616.26

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 MULTIPLE CASH FLOWS – FV
EXAMPLE 3
• Suppose you plan to deposit $100 into an account in one year
and $300 into the account in three years.
• How much will be in the account in five years if the interest rate is 8%?

 FV = 100(1.08)4 + 300(1.08)2 = 136.05 + 349.92 = 485.97

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 MULTIPLE CASH FLOWS – PV
(EXAMPLE 6.3)
• Find the PV of each cash flows and add them.
 Year 1 CF: 200 / (1.12)1 = 178.57
 Year 2 CF: 400 / (1.12)2 = 318.88
 Year 3 CF: 600 / (1.12)3 = 427.07
 Year 4 CF: 800 / (1.12)4 = 508.41
 Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1,432.93

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 EXAMPLE 6.3 TIMELINE
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93

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 MULTIPLE CASH FLOWS USING A
SPREADSHEET
• You can use the PV or FV functions in Excel to find
the present value or future value of a set of cash
flows.

• Setting the data up is half the battle – if it is set up

properly, then you can just copy the formulas.

• Click on the Excel icon for an example.

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 MULTIPLE CASH FLOWS – PV
ANOTHER EXAMPLE
• You are considering an investment that will pay you
$1,000 in one year, $2,000 in two years, and $3000
in three years.
• If you want to earn 10% on your money, how much would you be
willing to pay?

 PV = 1000 / (1.1)1 = 909.09

 PV = 2000 / (1.1)2 = 1,652.89
 PV = 3000 / (1.1)3 = 2,253.94
 PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.92

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 MULTIPLE UNEVEN CASH FLOWS –
USING THE CALCULATOR
• Another way to use the financial calculator for uneven cash flows is
to use the cash flow keys.

 Press CF and enter the cash flows beginning with year 0.

 You have to press the “Enter” key for each cash flow.
 Use the down arrow key to move to the next cash flow.
 The “F” is the number of times a given cash flow occurs in
consecutive periods.
 Use the NPV key to compute the present value by entering the
interest rate for I, pressing the down arrow and then compute.
 Clear the cash flow keys by pressing CF and then 2nd CLR Work.

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 DECISIONS, DECISIONS

• Your broker calls you and tells you that he has this great
investment opportunity.
• If you invest $100 today, you will receive $40 in one year
and $75 in two years.
• If you require a 15% return on investments of this risk,
should you take the investment?
 Use the CF keys to compute the value of the investment.
• CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1
• NPV; I = 15; CPT NPV = 91.49
No – the broker is charging more than you would be willing to
pay.
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 SAVING FOR RETIREMENT

• You are offered the opportunity to put some money

away for retirement.
• You will receive five annual payments of $25,000 each
beginning in 40 years.
• How much would you be willing to invest today if you
desire an interest rate of 12%?

 Use cash flow keys:

• CF; CF0 = 0; C01 = 0; F01 = 39; C02 = 25,000; F02 = 5; NPV; I =
12; CPT NPV = 1,084.71

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 SAVING FOR RETIREMENT
TIMELINE

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)

The cash flows in years 1 – 39 are 0 (C01 = 0; F01 = 39)
The cash flows in years 40 – 44 are 25,000 (C02 =
25,000; F02 = 5)
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 QUICK QUIZ – PART I

• Suppose you are looking at the following possible cash flows:

• Year 1 CF = $100;
• Years 2 and 3 CFs = $200;
• Years 4 and 5 CFs = $300.
• The required discount rate is 7%.

• What is the value of the cash flows at year 5?

• What is the value of the cash flows today?
• What is the value of the cash flows at year 3?

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 ANNUITIES AND PERPETUITIES
DEFINED
• Annuity – finite series of equal payments that occur
at regular intervals
 If the first payment occurs at the end of the period, it is
called an ordinary annuity.
 If the first payment occurs at the beginning of the period, it
is called an annuity due.

• Perpetuity – infinite series of equal payments

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 ANNUITIES AND PERPETUITIES –
BASIC FORMULAS
• Perpetuity: PV = C / r

• Annuities:

 1 
1 
(1  r ) t 
PV  C  
 r 

 

 (1  r ) t  1 
FV  C  
 r 

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 ANNUITIES AND THE
CALCULATOR
• You can use the PMT key on the calculator for the
equal payment.
• The sign convention still holds.
• Ordinary annuity versus annuity due
 You can switch your calculator between the two types by
using the 2nd BGN 2nd Set on the TI BA-II Plus.
 If you see “BGN” or “Begin” in the display of your
calculator, you have it set for an annuity due.
 Most problems are ordinary annuities.

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 ANNUITY – EXAMPLE 6.5

• After carefully going over your budget, you have determined

you can afford to pay $632 per month toward a new sports
car.
• You call up your local bank and find out that the going rate
is 1 percent per month for 48 months.
• How much can you borrow?

• To determine how much you can borrow, we need to calculate

the present value of $632 per month for 48 months at 1
percent per month.

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 ANNUITY – EXAMPLE 6.5 (CTD.)

• You borrow money TODAY so you need to compute

the present value.
 48 N; 1 I/Y; -632 PMT; CPT PV = 23,999.54 ($24,000)

• Formula:
 1 
1 
 (1 .01) 48 
PV  632    23,999 .54
 .01 
 

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 ANNUITY – SWEEPSTAKES
EXAMPLE
• Suppose you win the Publishers Clearinghouse $10
million sweepstakes.
• The money is paid in equal annual installments of
$333,333.33 over 30 years.
• If the appropriate discount rate is 5%, how much is the
sweepstakes actually worth today?

 PV = 333,333.33[1 – 1/1.0530] / .05 = 5,124,150.29

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 BUYING A HOUSE

• You are ready to buy a house, and you have $20,000 for a down payment
and closing costs.
• Closing costs are estimated to be 4% of the loan value.
• You have an annual salary of $36,000, and the bank is willing to allow
your monthly mortgage payment to be equal to 28% of your monthly
income.
• The interest rate on the loan is 6% per year with monthly compounding
(.5% per month) for a 30-year fixed rate loan.
• How much money will the bank loan you?
• How much can you offer for the house?

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 BUYING A HOUSE (CTD.)

• Bank loan
 Monthly income = 36,000 / 12 = 3,000
 Maximum payment = .28(3,000) = 840
 PV = 840[1 – 1/1.005360] / .005 = 140,105

• Total Price
 Closing costs = .04(140,105) = 5,604
 Down payment = 20,000 – 5,604 = 14,396
 Total Price = 140,105 + 14,396 = 154,501

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 ANNUITIES ON THE SPREADSHEET –
EXAMPLE
• The present value and future value formulas in a spreadsheet
include a place for annuity payments.

• Click on the Excel icon to see an example.

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 QUICK QUIZ – PART II

• You know the payment amount for a loan, and you

want to know how much was borrowed. Do you
compute a present value or a future value?

• You want to receive 5,000 per month in retirement.

• If you can earn 0.75% per month and you expect to need the income
for 25 years, how much do you need to have in your account at
retirement?

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 FINDING THE PAYMENT

• Suppose you want to borrow $20,000 for a new car.

• You can borrow at 8% per year, compounded monthly
(8/12 = .66667% per month).
• If you take a 4 year loan, what is your monthly payment?

 20,000 = C[1 – 1 / 1.006666748] / .0066667

 C = 488.26

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 FINDING THE PAYMENT ON A
SPREADSHEET
• Another TVM formula that can be found in a
spreadsheet is the payment formula.
 PMT(rate, nper, pv, fv)
 The same sign convention holds as for the PV and FV
formulas.

• Click on the Excel icon for an example.

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 FINDING THE NUMBER OF
PAYMENTS – EXAMPLE 6.6
• You ran a little short on your spring break vacation,
so you put $1,000 on your credit card.
• You can afford only the minimum payment of $20 per
month.
• The interest rate on the credit card is 1.5 percent per month.
• How long will you need to pay off the $1,000?

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 FINDING THE NUMBER OF
PAYMENTS – EXAMPLE 6.6 (CTD.)
• Start with the equation, and remember your logs.
 1,000 = 20(1 – 1/1.015t) / .015
 .75 = 1 – 1 / 1.015t
 1 / 1.015t = .25
 1 / .25 = 1.015t
 t = ln(1/.25) / ln(1.015) = 93.111 months = 7.76 years

• And this is only if you don’t charge anything more

on the card!

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 FINDING THE NUMBER OF
PAYMENTS – ANOTHER EXAMPLE
• Suppose you borrow $2,000 at 5%, and you are
going to make annual payments of $734.42.
• How long before you pay off the loan?

 2,000 = 734.42(1 – 1/1.05t) / .05

 .136161869 = 1 – 1/1.05t
 1/1.05t = .863838131
 1.157624287 = 1.05t
 t = ln(1.157624287) / ln(1.05) = 3 years

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 FINDING THE RATE

• Suppose you borrow $10,000 from your parents to

buy a car.
• You agree to pay $207.58 per month for 60 months.
• What is the monthly interest rate?

 Sign convention matters!!!

 60 N
 10,000 PV
 -207.58 PMT
 CPT I/Y = .75%

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 ANNUITY – FINDING THE RATE
WITHOUT A FINANCIAL CALCULATOR
• Trial and Error Process
 Choose an interest rate and compute the PV of the payments
based on this rate.
 Compare the computed PV with the actual loan amount.
 If the computed PV > loan amount, then the interest rate is too
low.
 If the computed PV < loan amount, then the interest rate is too
high.
 Adjust the rate and repeat the process until the computed PV and
the loan amount are equal.

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 QUICK QUIZ – PART III
• You want to receive $5,000 per month for the next 5 years.
• How much would you need to deposit today if you can earn
0.75% per month?
• What monthly rate would you need to earn if you only have
$200,000 to deposit?

• Suppose you have $200,000 to deposit and can earn 0.75%

per month.
• How many months could you receive the $5,000 payment?
• How much could you receive every month for 5 years?

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 FUTURE VALUES FOR ANNUITIES

• Suppose you begin saving for your retirement by depositing

$2,000 per year in an IRA.
• If the interest rate is 7.5%, how much will you have in 40 years?

 FV = 2,000(1.07540 – 1)/.075 = 454,513.04

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 ANNUITY DUE

• You are saving for a new house, and you put $10,000 per year
in an account paying 8%. The first payment is made today.
• How much will you have at the end of 3 years?

 FV = 10,000[(1.083 – 1) / .08](1.08) = 35,061.12

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 ANNUITY DUE TIMELINE
0 1 2 3

10000 10000 10000

32,464

35,016.12

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 PERPETUITY – EXAMPLE 6.7

• Suppose the Fellini Co. wants to sell preferred stock at $100

per share.
• A similar issue of preferred stock already outstanding has a price of
$40 per share and offers a dividend of $1 every quarter.
• What dividend will Fellini have to offer if the preferred stock is going
to sell?

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 PERPETUITY – EXAMPLE 6.7 (CTD.)

• Perpetuity formula: PV = C / r

• Current required return:

 40 = 1 / r
 r = .025 or 2.5% per quarter

• Dividend for new preferred:

 100 = C / .025
 C = 2.50 per quarter

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 QUICK QUIZ – PART IV

• You want to have $1 million to use for retirement in

35 years.
• If you can earn 1% per month, how much do you need to
deposit on a monthly basis if the first payment is made in
one month?
• What if the first payment is made today?

• You are considering preferred stock that pays a

quarterly dividend of $1.50.
• If your desired return is 3% per quarter, how much would
you be willing to pay?
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 WORK THE WEB EXAMPLE

• Another online financial calculator can be found at

MoneyChimp.

• Go to the website and work the following example:

 Choose calculator and then annuity.
 You just inherited $5 million. If you can earn 6% on your
money, how much can you withdraw each year for the next
40 years?
 MoneyChimp assumes annuity due!
 Payment = $313,497.81

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 TABLE 6.2

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 GROWING ANNUITY

A growing stream of cash flows with a fixed

maturity
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 )  
 

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 GROWING ANNUITY: EXAMPLE

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

year for 40 years and increase the annual payment by three-
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  

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 GROWING PERPETUITY

A growing stream of cash flows that lasts forever

C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2
(1  r ) 3

C
PV 
rg
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 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?

$ 1 . 30
PV   $ 26 . 00
. 10  . 05
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 EFFECTIVE ANNUAL RATE (EAR)

• This is the actual rate paid (or received) after

accounting for compounding that occurs during the
year

• If you want to compare two alternative investments

with different compounding periods, you need to
compute the EAR and use that for comparison.

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 ANNUAL PERCENTAGE RATE

• This is the annual rate that is quoted by law

• By definition APR = period rate times the number of periods

per year.

• Consequently, to get the period rate we rearrange the APR

equation:
 Period rate = APR / number of periods per year

• You should NEVER divide the effective rate by the number of

periods per year – it will NOT give you the period rate.

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 COMPUTING APRS

• What is the APR if the monthly rate is .5%?

 .5(12) = 6%

• What is the APR if the semiannual rate is .5%?

 .5(2) = 1%

• What is the monthly rate if the APR is 12% with monthly

compounding?
 12 / 12 = 1%

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 THINGS TO REMEMBER

• You ALWAYS need to make sure that the interest rate and the
time period match.
 If you are looking at annual periods, you need an annual rate.
 If you are looking at monthly periods, you need a monthly rate.

• If you have an APR based on monthly compounding, you

have to use monthly periods
for lump sums, or adjust the interest rate appropriately if you
have payments other than monthly.

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 COMPUTING EARS – EXAMPLE

• Suppose you can earn 1% per month on $1 invested today.

 What is the APR? 1(12) = 12%
 How much are you effectively earning?
• FV = 1(1.01)12 = 1.1268
• Rate = (1.1268 – 1) / 1 = .1268 = 12.68%

• Suppose if you put it in another account, you earn 3% per

quarter.
 What is the APR? 3(4) = 12%
 How much are you effectively earning?
• FV = 1(1.03)4 = 1.1255
• Rate = (1.1255 – 1) / 1 = .1255 = 12.55%
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 EAR – FORMULA

m
 APR 
EAR  1    1
 m 
Remember that the APR is the quoted rate, and
mRemember
is the number
that of
thecompounding periods
APR is the quoted perand
rate, year
m is the number of compounding periods per year

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 DECISIONS, DECISIONS II

• You are looking at two savings accounts. One pays 5.25%,

with daily compounding. The other pays 5.3% with
semiannual compounding. Which account should you use?

 First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
 Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%

• Which account should you choose and why?

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 DECISIONS, DECISIONS II (CTD.)

• Let’s verify the choice. Suppose you invest $100 in each

account. How much will you have in each account in one
year?

 First Account:
• Daily rate = .0525 / 365 = .00014383562
• FV = 100(1.00014383562)365 = 105.39
 Second Account:
• Semiannual rate = .0539 / 2 = .0265
• FV = 100(1.0265)2 = 105.37

• You have more money in the first account.

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 COMPUTING APRS FROM EARS

• If you have an effective rate, how can you compute the APR?
Rearrange the EAR equation and you get:


AP R  m (1  EAR)
1
m
-1 
 

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 APR – EXAMPLE

• Suppose you want to earn an effective rate of 12%

and you are looking at an account that compounds on
a monthly basis. What APR must they pay?

A P R  12 (1  . 12 )  1 /1 2

 1  . 113 8655152
or 11.39%
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 COMPUTING PAYMENTS WITH
APRS
• Suppose you want to buy a new computer system and the
store is willing to allow you to make monthly payments. The
entire computer system costs $3,500.
• The loan period is for 2 years, and the interest rate is 16.9% with
monthly compounding.
• What is your monthly payment?

 Monthly rate = .169 / 12 = .01408333333

 Number of months = 2(12) = 24
 3,500 = C[1 – (1 / 1.01408333333)24] / .01408333333
 C = 172.88

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 FUTURE VALUES WITH
MONTHLY COMPOUNDING
• Suppose you deposit $50 a month into an account
that has an APR of 9%, based on monthly
compounding.
• How much will you have in the account in 35 years?

 Monthly rate = .09 / 12 = .0075

 Number of months = 35(12) = 420
 FV = 50[1.0075420 – 1] / .0075 = 147,089.22

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 PRESENT VALUE WITH DAILY
COMPOUNDING
• You need $15,000 in 3 years for a new car.
• If you can deposit money into an account that pays an APR
of 5.5% based on daily compounding, how much would
you need to deposit?

 Daily rate = .055 / 365 = .00015068493

 Number of days = 3(365) = 1,095
 FV = 15,000 / (1.00015068493)1095 = 12,718.56

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 CONTINUOUS COMPOUNDING

• Sometimes investments or loans are figured based on

continuous compounding.
• EAR = eq – 1
 The e is a special function on the calculator normally
denoted by ex.

• Example: What is the effective annual rate of 7%

compounded continuously?
 EAR = e.07 – 1 = .0725 or 7.25%

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 QUICK QUIZ – PART V

• What is the definition of an APR?

• What is the effective annual rate?

• Which rate should you use to compare alternative investments

or loans?

• Which rate do you need to use in the time value of money

calculations?

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 PURE DISCOUNT LOANS –
EXAMPLE 6.12
• 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

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 INTEREST-ONLY LOAN – EXAMPLE

• Consider a 5-year, interest-only loan with a 7%

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.
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 AMORTIZED LOAN WITH FIXED
PRINCIPAL PAYMENT – EXAMPLE
• Consider a $50,000, 10 year loan at 8% interest. The
loan agreement requires the firm to pay $5,000 in
principal each year plus interest for that year.

• Click on the Excel icon to see the amortization table.

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 AMORTIZED LOAN WITH FIXED
PAYMENT – EXAMPLE
• Each payment covers the interest expense plus reduces
principal.
• Consider a 4 year loan with annual payments. The interest rate
is 8%, and the principal amount is $5,000.
 What is the annual payment?
• 4N
• 8 I/Y
• 5,000 PV
• CPT PMT = -1,509.60
• Click on the Excel icon to see the amortization table.

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 WORK THE WEB EXAMPLE-2

• There are websites available that can easily prepare

amortization tables.

• Check out the Bankrate website and work the following

example.

• You have a loan of $25,000 and will repay the loan over 5
years at 8% interest.
 What is your loan payment?
 What does the amortization schedule look like?

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 QUICK QUIZ – PART VI

• What is a pure discount loan?

• What is a good example of a pure discount loan?

• What is an interest-only loan?

• What is a good example of an interest-only loan?

• What is an amortized loan?

• What is a good example of an amortized loan?

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 ETHICS ISSUES

• Suppose you are in a hurry to get your income tax refund.

• If you mail your tax return, you will receive your refund in 3 weeks.
• If you file the return electronically through a tax service, you can get the
estimated refund tomorrow.
• The service subtracts a $50 fee and pays you the remaining expected refund.
The actual refund is then mailed to the preparation service.
• Assume you expect to get a refund of $978.
• What is the APR with weekly compounding?
• What is the EAR?
• How large does the refund have to be for the APR to be 15%?
• What is your opinion of this practice?

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 COMPREHENSIVE PROBLEM
• An investment will provide you with $100 at the end of each
year for the next 10 years. What is the present value of that
annuity if the discount rate is 8% annually?
• What is the present value of the above if the payments are
received at the beginning of each year?
• If you deposit those payments into an account earning 8%,
what will the future value be in 10 years?
• What will the future value be if you open the account with
$1,000 today, and then make the $100 deposits at the end of
each year?

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 END OF CHAPTER
CHAPTER 6 - FORMULAS

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