Chapter 05

Discounted Cash Flow

Valuation
Chapter 05
Discounted Cash Flow
Valuation
 :
1. Elaine has just received an insurance settlement of $25,000. She wants
to save this money until her daughter goes to college. If she can earn an
average of 6.5 percent, compounded annually, how much will she have
saved when her daughter enters college 8 years from now?
A. $38,000.00
B. $40,929.02
C. $41,374.89
D. $41,899.60
E. $42,000.00
2. You just won $25,000 and deposited your winnings into an account that
pays 6.2 percent interest, compounded annually. How long will you
have to wait until your winnings are worth $50,000?
A. 11.52 years
B. 12.00 years
C. 12.29 years
D. 12.67 years
E. 12.90 years
 Key Concepts and Skills
● Be able to compute the future value of
multiple cash flows
● Be able to compute the present value of
multiple cash flows
● Be able to compute loan payments
● Be able to find the interest rate on a loan
● Understand how loans are amortized or paid
off
● Understand how interest rates are quoted
5-3
 Chapter Outline
5.1 Future and Present Values of
Multiple Cash Flows

5.2 Valuing Level Cash Flows:

Annuities and Perpetuities

5.3 Comparing Rates: The Effect

of Compounding Periods

5.4 Loan Types and Loan Amortization

 (1)
Annuity
Ordinary Annuity

Annuity Due
• Annuity Present value

• Annuity Future value

Perpetuity
Perpetuity present value
 (2)
➢ (Ordinary) Annuity: A level stream of cash flows for a
fixed period of time.
➢ Annuity due: An annuity for which the cash flows occur
at the beginning of the period.
➢ Perpetuity: An annuity in which the cash flows continue
forever.
➢ Stated interest rate: The interest rate expressed in terms
of the interest payment made each period. Also, quoted
interest rate.
 (3)
➢ Effective annual rate (EAR): The interest rate expressed
as if it were compounded once per year.
➢ Annual percentage rate (APR): The interest rate
charged per period multiplied by the number of periods
per year.
➢ Pure discount loan: The pure discount loan is the
simplest form of loan. With such a loan, the borrower
receives money today and repays a single lump sum at
some time in the future.
 (4)
➢ Interest-only loan: A second type of loan has a repayment plan
that calls for the borrower to pay interest each period and to
repay the entire principal at some point in the future. Such loans
are called interest-only loans. Notice that if there is just one
period, a pure discount loan and an interest-only loan are the
same thing.
➢ Amortized loan: With a pure discount or interest-only loan,
the principal is repaid all at once. An alternative is an amortized
loan, with which the lender may require the borrower to repay
parts of the loan amount over time. The process of paying off a
loan by making regular principal reductions is called amortizing
the loan.
 Multiple Cash Flows
Computational Methods
● TVM Formulas
● Texas Instruments BA II+
● PV/FV keys
● CashFlow Worksheet
• Present Value only
● Excel Spreadsheet/Functions

5-10
 Multiple Cash Flows –
FV Example 1
Find the value at year 3 of each cash flow
and add them together.
Today (year 0): FV = 7,000(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

 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

 Multiple Cash Flows –
FV Example 2

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
 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
 Example 3 Timeline
0 1 2 3 4 5

100 300

136.05

349.92

485.97
 Multiple Cash Flows –
Present Value Example 1

Find the PV of each cash flow 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
 PV Example 1 Timeline
0 1 2 3 4

200 400 600 800

178.57
318.88

427.07
508.41

1,432.93
 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

Texas Instruments BA-II Plus

• Clear the cash flow keys by pressing CF and then 2nd CLR Work

• 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 years

• Use the NPV key to compute the present value by [ENTER]ing the
interest rate for I, pressing the down arrow and then compute
 TI BAII+: Uneven Cash Flows

Cash Flows: Display You Enter

‘'
CF0 = 0 C00 0 !#
CF1 = 200 C01 200 !#
F01 1 !#
CF2 = 400 C02 400 !#
F02 1 !#
CF3 = 600
C03 600 !#
CF4 = 800 F03 1 !#
C04 800 !#
F04 1 !# (
NPV
I 12 !#
CPT %
1432.93
5-19
Excel
 Multiple Cash Flows –
Present Value Example 2
You are considering an investment that will pay you
$1,000 in one year, $2,000 in two years and $3,000 in
three years. If you want to earn 10% on your money,
how much would you be willing to pay?

PV = 1,000 / (1.1)1 = 909.09

PV = 2,000 / (1.1)2 = 1,652.89

PV = 3,000 / (1.1)3 = 2,253.94

PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.92

 Multiple Cash Flows – Present Value
Example 3 (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 2nd ClrWork; 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.
 Multiple Cash Flows – Present Value
Example 4 (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
 Saving For
Retirement Timeline
01 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 years 1 – 39 are 0 (C01 = 0; F01 = 39)

The cash flows years 40 – 44 are 25,000

(C02 = 25,000; F02 = 5)
 Example: Spreadsheet Strategies

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

 Quick Quiz: Part 1
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?

 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

 Annuities and Perpetuities –
Basic Formulas
Perpetuity :

PV = C / r

Annuities:
 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

 Annuity PV – Example 1

You can afford $632 per month. Going

rate = 1%/month for 48 months. How
much can you borrow?
You borrow money TODAY so you need to
compute the present value.
Formula:

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

 Annuity PV– Sweepstakes Example 2
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

 Annuity PV- Example 3
(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?
 Annuity PV-Buying a House
Bank loan
Monthly income = 36,000 / 12 = 3,000

Maximum payment = .28(3,000) = 840

PV = 840[1 – 1/1.005360] / .005 = 140,105

=PV(.005,360,-840,0)=140,105

Total Price
Closing costs = .04(140,105) = 5,604

Down payment = 20,000 – 5604 = 14,396

Total Price = 140,105 + 14,396 = 154,501

 Example: Spreadsheet
Strategies – Annuity PV
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

 Annuity-PV: Example 4
Finding the Payment (C )
Suppose you want to borrow $20,000 for a new
car. You can borrow at 8% per year,
compounded monthly (8/12 = .666666667% 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

=PMT(0.006667,48,20000,0)
 Example: Spreadsheet
Strategies – Annuity Payment
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

 Annuity-PV: Example 5
(Finding the Number of Payments (t))
You have $1,000 due on credit card. The Payment =
$20 month minimum and Rate = 1.5% per month.

1000 = 20(1 – 1/1.015t) / .015

1 / 1.015t = .25

1 / .25 = 1.015t

t = ln(1/.25) / ln(1.015) = 93.111 months = 7.75 years

1000 PV;1.5 I/Y; -20PMT; CPT N = 7.75

 Annuity-PV: Example 6
(Finding the Number of Payments (t))
Suppose you borrow $2000 at 5% and you are
going to make annual payments of $734.42.
How long before you pay off the loan?
2000 = 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

2000 PV;5 I/Y; -734.42 PMT; CPT t = 3

 Annuity-PV: Example 7
(Finding the Rate (r ))
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%

=RATE(60,-207.58,10000,0)
 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
 Quick Quiz: Part 2
(Annuity-PV)
You are looking into an investment that
will pay you $12,000 per year for the next
10 years. If you require a 15 percent
return, what is the most you would pay for
this investment?
 Quick Quiz: Part 2
(Annuity-PV)
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 .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?
 Quick Quiz: Part 2
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 .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 .75% per month.

How many months could you receive the $5,000

payment?
How much could you receive every month for 5
years?
 Future Values for Annuities-
Suppose you beginExample 1
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(Ordinary) = 2,000(1.07540 – 1)/.075 =

454,513.04

40 N; 7.5 I/Y; -2000 PMT; CPT FV =

454,513.04
 Annuity Due ( )-
Example 2
You are saving for a new house and you put
$10,000 per year in an account payingo
8%.
The first payment is made today. How much
will you have at the end ofo
3 years?

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

=FV(0.08,3,-10000,0,1)
 Annuity Due Timeline

0 1 2 3

10000 10000 10000

32,464

35,016.12
 Perpetuity – Example 1

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

 Table 5.2 Summary of
Annuity and Perpetuity Calculations
 Quick Quiz: Part 3

Suppose you plan to contribute $2,000 at

the end of every year into a retirement
account paying 8 percent. If you retire in
30 years. How much will you have? What
if the first payment is made today?
 Quick Quiz: Part 3
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?
 Example: Work the Web

● Another online financial calculator can

be found at Calculatoredge.com.
● Click on the Web surfer, select
“Finance” calculator and “Annuity
Payments” and work the following
example:
● How much could you withdraw each year if
you have $2,500,000, earn 8 % and make
annual withdrawals for 35 years?
5-50
 Interest Rates
● Effective Annual Rate (EAR) ( mn
)
● The interest rate expressed as if it were compounded once per
year.
● Used to compare two alternative investments with different
compounding periods

● Annual Percentage Rate (APR) “Nominal” ( )

● The annual rate quoted by law
● APR = periodic rate X number of periods per year

Period rate = APR / number of periods per year

5-51
 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%

Can you divide the above APR by 2 to get the semiannual

rate? NO!!! You need an APR based on semiannual
compounding to find the semiannual rate.
 Things to Remember

● You ALWAYS need to make sure that the

interest rate and the time period match.
● Annual periods annual rate.
● Monthly periods 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 accordingly.
5-53
 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%

 Computing EARs - Example
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%

 EAR - Formula

Remember that the APR is the quoted rate,

and m is the number of compounds per year
 EAR and APR in TI BA II+
● 3 fields in worksheet:
● NOM (Nominal rate-APR) #
● EFF (Effective annual rate) #
● C/Y (Compounding periods/yr) #

● Enter any 2 values, move to the 3rd and press %

5-57
 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%

•NOM=5.25; C/Y=365 EFF=5.3899
Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%
•NOM=5.3; C/Y=2 EFF=5.3702
Which account should you choose and why?
 Decisions, Decisions II
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 = .053 / 2 = .0265

• FV = 100(1.0265)2 = 105.37

You have more money in the first account.

 Computing APRs from EARs

If you have an effective rate, how can you

compute the APR? Rearrange the EAR
equation and you get:
 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?

•EFF=12; C/Y=12 NOM=5.3899

 Computing Payments with
Suppose you want to buyAPRs
a new computer system and
the store is willing to sell it and allow you to make
monthly payments. The entire computer system costs
$3500. 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

3500 = C[1 – 1 / 1.01408333333)24] / .01408333333

C = 172.88
 Future Values with
Monthly Compounding
Suppose you deposit $50 per 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

 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) = 1095

FV = 15,000 / (1.00015068493)1095 = 12,718.56

 Quick Quiz: Part 4

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?
 Pure Discount Loans –
Example 1
Treasury bills are excellent examples of pure
discount loans.
-The principal amount is repaid at some future
date.
-No 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
=PV(.07,1,0,10000)
 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.
 Amortized Loan with
Equal principal payment
Suppose a business takes out a $5,000, five-year
loan at 9 percent, the borrower to reduce the
loan balance each year by $1,000.
 Amortized Loan with
Fixed Payment – Example 1
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 $5000.
What is the annual payment?
• 5,000 = C[1 – 1 / 1.084] / .08

• C = 1,509.60
 Example: Spreadsheet Strategies
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 $5000.
What is the annual payment?
• 4N
• 8 I/Y
• 5000 PV
• CPT PMT = -1509.60

Click on the Excel icon to see the amortization table

 Amortization Table for Example

Beg. Total Interest Principal End.

Year
Balance Payment Paid Paid Balance

1 5,000.00 1509.60 400.00 1109.60 3890.40

2 3890.40 1509.60 311.23 1198.37 2692.03

3 2692.03 1509.60 215.36 1294.24 1397.79

4 1397.79 1509.60 111.82 1397.78 .01

Totals 6038.40 1038.41 4999.99

 Amortized Loan with
Fixed Payment – Example 2
Consider a 5 year loan with annual fixed payments.
The interest rate is 9% and the principal amount is
$5000.
 Quick Quiz

Suppose you borrow $10,000. You are going to

repay the loan by making equal annual
payments for five years. The interest rate on
the loan is 14 percent per year. Prepare an
amortization schedule for the loan.
 Quick Quiz

NT$6,000
30

20

3%
 Quick Quiz-Amortized Loan
60,000

1,650,000 1,000,000
500,000 150,000

1/3( 20,000 ) 20
3%(
1
) ?
 ( )

( )
( )
● ( )
● (20,30,40)
●
Assume: 1,000 (APR)1.3%
20 30 40

47,340 33,560 26,728

10,833

● :

●
 Quick Quiz: Part 5

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?
 Example: Work the Web
Several web sites have calculators that will prepare
amortization tables quickly

One such site is LendingTree.com

Click on the web surfer and follow knowledge center,

mortgage calculators, “How much will your mortgage
payments be” and enter the following information:
Loan amount = 20,000

Term = 10 years
Clicking “View Report” will give
Interest rate = 7.625% you the amortization table

What is the monthly payment?

Using the calculator you will get $238.71

Chapter review and Self-test Problems

Questions and Problems:1,3,4,9,14,23,30,55

 :
• Which one of the following has the highest effective annual rate?
A. 6 percent compounded annually
B. 6 percent compounded semi-annually
C. 6 percent compounded quarterly
D. 6 percent compounded monthly
E. All the other answers have the same effective annual rate.
2. Which one of the following qualifies as an annuity?
A. Weekly grocery bill
B. Clothing purchases
C. Car repairs
D. Auto loan payment
E. Medical bills
(%)
15-20
15-20

15-20

15-20
6-12

8-10

10-15

10-15

7-10

8-10
 ( )

( )
( )
Step1
 Step2

A. = x3
B.

Step2 = A + B
 Step3
Step1

160
6 30

160 – 6 - 30 = 124
Step4
 Step5

Step4 x 40% =
Step4 7.5

7.5 x 40% = 3
 Step6
4% 20

Step5÷0.00606(20 )=
Step5
3

30000 ÷ 0.00606 = 495

Step7 = Step3 + Step6

+ = 124 + 495 = 619

Thank You !