How to calculate present values

Back to the future

Chapter 3

Discounted Cash Flow Analysis

(Time Value of Money)
• Discounted Cash Flow (DCF) analysis is the foundation of
valuation in corporate finance

• To use DCF we need to know three things

• The size of the expected cash flows
• The timing of the cash flows
• The proper discount (interest) rate

• DCF allows us to compare the values of alternative cash

flow streams in dollars today (Present Value)

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 FUTURE VALUE
(COMPOUNDING):
What will $100 grow to after 1 year at 10% ?
0 10% 1
|----------------------|
-100
interest 10
end of period value 110

FV1 = PV0 (1+r) = 100 (1.1) = 110

where FV1 is the future value in period 1
PV0 is the present value in period 0 (today)

NOTE: When r=10%, $100 received now (t=0) is

equivalent to $110 received in one year (t=1).

What will $100 grow to after 2 years at 10% ?

0 10% 1 10% 2
|---------------------|---------------------|
100
interest 10 11
end of period value 110 121

FV2 = PV0 (1+r) (1+r)= PV0 (1+r)2

= 100 (1.1)2 = 100 (1.21) = 121

NOTE: $100 received now (t=0) is equivalent to

$110 received in one year (t=1) which is also
equivalent to $121 in 2 years (t=2).

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 The general formula for future value in year N (FVN)

FVN = PV0 (1+r)N

What will $100 grow to after 8 years at 6% ?

What is the present value of $159.40 received

in 8 years at 6%?
Or
How much would you have to invest today at 6%
in order to have $159.40 in 8 years?

COMPOUND INTEREST
Future value of $1
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FUTURE VALUE
16 Year 5% 10% 15%
1 1.050 1.100 1.150
14 2 1.103 1.210 1.323
5 1.276 1.331 2.011
12
10 1.629 2.594 4.046
10 20 2.653 6.727 16.37

0
0 2 4 6 8 10 12 14 16 18 20
Year
r = 5% r = 10% r = 15%

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 PRESENT VALUE IS THE RECIPROCAL
OF FUTURE VALUE:

PV0 = FVN /(1+r)N

Note: Brealey & Myers refer to 1/(1+r)N as a

“discount factor”.

The discount factor for 8 years at 6% is

1/(1+.06)8 = 0.627

Thus, the present value of $1.00 in 8 years

at 6% is $0.627.

What’s the present value of $50 in 8 years?

PRESENT VALUES
Present value of $1 PRESENT VALUE
1
Year 5% 10% 15%
1 .952 .909 .870
0.8 2 .907 .826 .756
5 .784 .621 .497
10 .614 .386 .247
0.6 20 .377 .149 .061

0.4
r = 5%

0.2
r = 10%
0 r = 15%
0 2 4 6 8 10 12 14 16 18 20

Years

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PRESENT VALUE PROBLEMS
Which would you prefer at r=10%?
$1000 today vs. $2000 in 10 years

There are 4 variables in the analysis

PV, FV, N, and r

Given three, you can always solve

for the other

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 Four related questions:
2.1. How much must you deposit today to
have $1 million in 25 years? (r=.12)

2.2. If a $58,820 investment yields $1 million in

25 years, what is the rate of interest?

2.3. How many years will it take $58,820 to

grow to $1 million if r=.12?

2.4. What will $58,820 grow to after 25 years

if r=.12?

Present Value Of An Uneven Cash Flow

Stream
• In general, the present value of a stream of cash flows
can be found using the following general valuation
formula.
C1 C2 C3 CN
PV = + + + ... +
(1+ r1) (1+ r2 )2 (1+ r3 )3 (1+ rN )N
N
Ct
=∑
t =1 (1 + rt )
t

• In other words, discount each cash flow back to the

present using the appropriate discount rate and then
sum the present values.

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 Example
r (%)
8

year A PV B PV
1 100 92.59259 300 277.7778
2 400 342.9355 400 342.9355
3 400 317.5329 400 317.5329
4 400 294.0119 400 294.0119
5 300 204.175 100 68.05832

Present Value 1251.248 1300.316

Who got the better contract?

Emmitt or Thurman?
($ millions)

8
7
6
5 Thurman
Emmitt
4
3
2
1
0
93 94 95 96
Thurman 4 2.7 2.7 4.1
Emmitt 7 2.2 2.4 2

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PERPETUITIES
Offer a fixed annual payment (C) each year
in perpetuity.
C C C
…
0 1 2 3

How do you determine present value?

PV = C/(1+r) + C/(1+r)2 + C/(1+r)3 + …

Fortunately, a simple formula

PV0 of a perpetuity = C1/r

An example
Perpetuity: $100 per period forever discounted at 10% per period
100 100 100
…
0 1 2 3

… and some intuition

Consider a $1000 deposit in a bank

account that pays 10% per year.

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GROWING PERPETUITIES
Annual payment grows at a constant rate, g.
C C(1+g) C(1+g)2
…
0 1 2 3

How do you determine present value?

PV = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + …

Fortunately, a simple formula

PV0 of a growing perpetuity = C1/(r-g)

An example

Growing perpetuity: $100 received at time t =1,

growing at 2% per period with a discount rate of 10%

C C(1 + g) C(1 + g) 2
…
0 1 2 3

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 An example

An investment in a growing perpetuity costs

$5000 and is expected to pay $200 next year.
If the interest rate is 10%, what is the growth
rate of the annual payment?

Annuities

n An annuity is a series of equal payments (PMT on your

calculator) made at fixed intervals for a specified number
of periods
• e.g., $100 at the end of each of the next three years
n If payments occur at the end of each period it is an
ordinary annuity--(This is most common)
n If payments occur at the beginning of each period it is an
annuity due

0 1 2 3
Ordinary Annuity
100 100 100

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 Annuities
• The present value of an ordinary annuity that pays
a cash flow of C per period for T periods when the
discount rate is r is

C C C C
…
0 1 2 T-1 T

1 1 
PV = C  − T
 r r (1 + r ) 

Annuities

n A T-period annuity is equivalent to the difference

between two perpetuities. One beginning at time
zero, and one with first payment at time T+1.
C C C C C C
… minus …
0 1 2 3 T+1 T+2 T+3

n This implies that

C C 1  1 1 
PV = −   = C  − 
r r  (1 + r ) T   r r (1 + r )
T


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 Example

• Compute the present value of a 3 year ordinary

annuity with payments of $100 at r=10%
• Answer:
1 1 1
PVA 3 = 100 + 100 + 100 = $248.68
1.1 1.1 2 1.1
3

Or

 1 1 
PVA 3 = 100  -  = $248.68
3 
 0.1 0.1(1.1 ) 

What is the relation between a lump sum

cash flow and an annuity?
• What is the present value of an annuity that promises
$2000 per year for 5 years at r=5%?
year PMT PV (t=0)
1 2,000.00 1,904.76
2 2,000.00 1,814.06
3 2,000.00 1,727.68
4 2,000.00 1,645.40
5 2,000.00 1,567.05
_________
8,658.95

 1 1 
PVA 3 = 2000 -  = $8658.95
5
 0.05 0.05(1.05 ) 

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 • Alternatively, suppose you were given
$8,658.95 today instead of the annuity

year principal interest PMT Ending Bal

1 $ 8,658.95 $ 432.95 $ (2,000.00) $ 7,091.90
2 $ 7,091.90 $ 354.60 $ (2,000.00) $ 5,446.50
3 $ 5,446.50 $ 272.32 $ (2,000.00) $ 3,718.82
4 $ 3,718.82 $ 185.94 $ (2,000.00) $ 1,904.76
5 $ 1,904.76 $ 95.24 $ (2,000.00) $ 0.00

• Notice that you can duplicate the cash flows from

the annuity by investing your money from the
lump sum to earn the required rate of return (5%
in this example).

A Net Present Value Problem

What is the value today of a 10-year annuity that pays $300 a
year (at year-end) if the annuity’s first cash flow starts at the
end of year 6 and the interest rate is 10%?

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 Other Compounding Intervals

n Cash flows are often compounded over

periods other than annually
• Consumer loans are compounded
monthly
• Bond coupons are received semiannually

Compounding
Annual: 1
|------------------------------------------------------------|
100 110.00
Semi-annual:
.5 1
|-------------------------------|------------------------------|

Quarterly:
.25 .5 .75 1
|-------------|----------------|---------------|--------------|

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 Example
• Find the PV of $500 received in the future under the
following conditions.
• 12% nominal rate, semiannual compounding, 5 years
500
PV = 10
= $ 279 . 20
 0 . 12 
1 + 
 2 
♦ 12% nominal rate, quarterly compounding, 5 years

500
PV = 20
= $ 276 . 84
 0 . 12 
1 + 
 4 

Future value of $1.00 in N years when interest

is compounded M times per year

FVN = (1 + r/M) MN
Continuous compounding :
As M approaches infinity...
… (1 + r/M) MN approaches erN
where e = 2.718

Example: The future value of $100 continuously

compounded at 10% for one year is
100 e .10 = 110.52

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 Summary
• Discounted cash flow analysis is the foundation
for valuing assets
• To use DCF you need to know three things
– Size of expected cash flows
– Timing of cash flows
– Discount rate (reflects the risk of cash flows)
• When valuing a stream of cash flows, search for
components such as annuities that can be easily
valued
• Compare different streams of cash flows in
common units using present value

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