CH 06

Fundamentals of Corporate
Finance, 2/e
ROBERT PARRINO, PH.D.

DAVID S. KIDWELL, PH.D.
THOMAS W. BATES, PH.D.
Chapter 6: Discounted Cash Flows and
Valuation
Learning objectives
1. Explain why cash flows occurring at different
times must be adjusted to reflect their value
as of a common date before they can be
compared, and compute the present value
and future value for multiple cash flows.
2. Describe how to calculate the present value
and the future value of an ordinary annuity
and how an ordinary annuity differs from an
annuity due.
Learning Objectives
3. Explain what a perpetuity is and where we see
them in business and calculate the value of a
perpetuity.
4. Discuss growing annuities and perpetuities, as
well as their application in business, and
calculate their values.
5. Discuss why the effective annual interest rate
(ear) is the appropriate way to annualize
interests rates, and calculate the ear.
Multiple Cash Flows
o FUTURE VALUE OF MULTIPLE CASH FLOWS
1. Draw a timeline to determine the number of
periods for which each cash flow will earn the
rate-of-return
2. Calculate the future value of each cash flow
using Equation 5.1
3. Add the future values
Future Value of Two Cash Flows
Exhibit 6.1 Future Value of Two Cash Flows

This exhibit shows a timeline for two cash flows invested in a
savings account that pays 10 percent interest annually. The
total amount in the savings account after two years is $2,310,
which is the sum of the future values of the two cash flows.
6
Future Value of Three Cash Flows
Exhibit 6.2 Future Value of Three Cash Flows

The exhibit shows a timeline for an investment program
with a three-year horizon. The value of the investment at
the end of three years is $3,641, the sum of the future
values of the three separate cash flows.
Present Value of Three Cash Flows
8
Level Cash Flows: Annuities and Perpetuities
o ANNUITY
• A series of equally-spaced and level cash flows
extending over a finite number of periods
o PERPETUITY
• A series of equally-spaced and level cash flows
that continue forever
o ORDINARY ANNUITY
• cash flows occur at the end of a period
mortgage payment
interest payment to bondholder
Exhibits 6.1, 6.2, and 6.3
o ANNUITY DUE
• cash flows occur at the beginning of a period
lease
Exhibit 6.7
o CALCULATE PRESENT VALUE OF AN ANNUITY

• To calculate a future value or a present value is
to calculate an equivalent amount
• The amount reflects an adjustment to account
for the effect of compounding

Present value of an annuity
amount needed produce the annuity
current fair value or market price of the annuity
amount of a loan that can be repaid with the annuity
IMPORTANT
o PRESENT VALUE OF AN ANNUITY EXAMPLE

• A contract will pay $2,000 at the end of each
year for three years and the appropriate discount
rate is 8%. What is a fair price for the contract?
13
IMPORTANT
PV annuity factor
Present value factor
14
Present Value Annuity Factors
15
o CALCULATE AN ANNUITY EXAMPLE

• You borrow $400,000 to buy a home. The 30-
year mortgage requires 360 monthly payments
at a monthly rate of 6.15%/12 or 0.5125%. How
much is the monthly payment?
16
o LOAN AMORTIZATION
• How borrowed funds are repaid over the life of
a loan
• Each payment includes less interest and more
principal; the loan is paid off with the last
payment
• Amortization schedule shows interest and
principal in each payment, and amount of
principal still owed after each payment
Amortization Table for a 5-Yr, $10,000 Loan at
5% Interest
18
Using Excel – Loan Amortization Table
Using Excel – Calculating the Interest Rate for
an Annuity
o FINDING THE INTEREST RATE

• The present value of an annuity equation can be
used to find the interest rate or discount rate for
an annuity
• To determine the rate-of-return for an annuity,
solve the equation for i
• Using a calculator is easier than a trial-and-error
approach
Future Value of 4-Yr Annuity: Colnago C50
Bicycle
Exhibit 6.6
The exhibit shows a timeline for a savings plan to buy a Colnago
C50 bicycle. Under this savings plan, $1,000 is invested at the end
of each year for four years at an annual interest rate of 8 percent.
We find the value at the end of the four-year period by adding the
future values of the separate cash flows, just as in Exhibits 6.1 and
6.2. 22
o FUTURE VALUE OF AN ANNUITY

• The future value of an annuity equation is
derived from Equation 6.1
23
o FUTURE VALUE OF AN ANNUITY

• The future value of an annuity equation is
derived from Equation 6.1
24
o PERPETUITY
• A stream of equal cash flows that goes on
forever
• Preferred stock and some bonds are perpetuities
• Equation for the present value of a perpetuity
can be derived from the present value of an
annuity equation
25
o PRESENT VALUE OF A PERPETUITY
26
o VALUING PERPETUITY EXAMPLE

• Suppose you decide to endow a chair in finance.
The goal of the endowment is to provide
$100,000 of financial support per year forever. If
the endowment earns a rate of 8%, how much
money will you have to donate to provide the
desired level of support?
27
Ordinary Annuity versus Annuity Due
28
o ORDINARY ANNUITY VERSUS ANNUITY DUE

• Present Value of Annuity Due
Cash flows are discounted for one period less than in an
ordinary annuity.
• Future Value of Annuity Due
Cash flows are earn compound interest for one period
more than in an ordinary annuity.
29
o ORDINARY ANNUITY VERSUS ANNUITY DUE

• The present value or future value of an annuity
due is always higher than that of an ordinary
annuity that is otherwise identical.
30
Cash Flows That Grow at a Constant Rate
o GROWING ANNUITY
• equally-spaced cash flows that increase in size
at a constant rate for a finite number of periods
o GROWING PERPETUITY
• equally-spaced cash flows that increase in size
at a constant rate forever
o GROWING ANNUITY
• Multiyear product or service contract with
periodic cash flows that increase at a constant
rate for a finite number of years
• Common stock whose dividend is expected to
increase at a constant rate forever
32
IMPORTANT

o GROWING ANNUITY
• Calculate the present value of growing annuity
(only) when the growth rate is less than the
discount rate.
33
o GROWING ANNUITY EXAMPLE
• A coffee shop will operate for fifty more years.
Cash flow was $300,000 last year and increases
by 2.5% each year. The discount rate for similar
firms is 15%. Estimate the value of the firm.
• Use Equation 6.6 to calculate the present value
of growing perpetuity (only) when the growth
rate is less than discount rate.
• It is derived from equation 6.5 when the number
of periods approaches infinity
35
o GROWING PERPETUITY EXAMPLE
• A firm’s cash flow was $450,000 last year. You
expect the cash flow to increase by 5% per year
forever. If you use a discount rate of 18%, what
is the value of the firm?
36
IMPORTANT
The Effective Annual Interest Rate

o DESCRIBING INTEREST RATES
• The most common way to quote interest rates is
in terms of annual percentage rate (APR). It
does not incorporate the effects of
compounding.
• The most appropriate way to quote interest rates
is in terms of effective annual rate (EAR). It
incorporates the effects of compounding.
37
o CALCULATE ANNUAL PERCENTAGE RATE (APR)
• APR = (periodic rate) x m
m is the # of periods in a year
• APR does not account for the number of
compounding periods or adjust the annualized
interest rate for the time value of money
• APR is not a precise measure of the rates
involved in borrowing and investing
38
IMPORTANT

o ANNUAL PERCENTAGE RATE (APR) EXAMPLE
• Anna is charged 1% interest when she borrows
$2000 for one week. What is the annual
percentage interest rate (APR) on the loan?
39
IMPORTANT

o EFFECTIVE ANNUAL INTEREST RATE (EAR)
• EAR accounts for the number of compounding
periods and adjusts the annualized interest rate
for the time value of money
• EAR is a more accurate measure of the rates
involved in lending and investing
40
o EFFECTIVE ANNUAL RATE (EAR) EXAMPLE
• Anna is charged 1% interest when she borrows
$2000 for one week. What is the effective annual
interest rate (EAR)?
41
o EFFECTIVE ANNUAL RATE (EAR) EXAMPLE
• Your credit card has an APR of 12 % (1% per
month). What is the EAR?
42

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Fundamentals of Corporate

ROBERT PARRINO, PH.D.

Exhibit 6.1 Future Value of Two Cash Flows

Exhibit 6.2 Future Value of Three Cash Flows

o CALCULATE PRESENT VALUE OF AN ANNUITY

o CALCULATE PRESENT VALUE OF AN ANNUITY

Level Cash Flows: Annuities and Perpetuities

o PRESENT VALUE OF AN ANNUITY EXAMPLE

Level Cash Flows: Annuities and Perpetuities

o CALCULATE PRESENT VALUE OF AN ANNUITY

Present value factor

o CALCULATE AN ANNUITY EXAMPLE

o FINDING THE INTEREST RATE

o FUTURE VALUE OF AN ANNUITY

o FUTURE VALUE OF AN ANNUITY

o PRESENT VALUE OF A PERPETUITY

o VALUING PERPETUITY EXAMPLE

o ORDINARY ANNUITY VERSUS ANNUITY DUE

o ORDINARY ANNUITY VERSUS ANNUITY DUE

Cash Flows That Grow at a Constant Rate

The Effective Annual Interest Rate

The Effective Annual Interest Rate

The Effective Annual Interest Rate

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