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Six
Discounted Cash
Flow Valuation
6.2
6.3
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
6.4
7,000
4,000
4,000
FV PV 1 r
3
4,000.00
4,320.00
4,665.60
8,817.98
$21,803.58
6.5
500
600
2
654.00
594.05
$1,248.05
9%
6.6
500
600
9%
846.95
769.31
$ 1,616.26
6.7
1
100
3
300
8%
349.92
136.05
$ 485.97
6.8
200
400
600
800
178.57
318.88
427.07
508.41
1,432.93
PV
FV
1 r
12%
6.9
Answer:
$4,815.93
6.10
6.11
6.12
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
100 +/CF
Note: NPV (Net Present Value) is the
addition to, or the destruction of, wealth
40
CF
that occurs from undertaking an
75
CF
investment. If NPV is positive, you
15
I/Y
create wealth. If NPV is negative, you
destroy wealth. Therefore, the decision
2nd NPV
-8.51
6.13
Year 1 CF = $100;
Years 2 and 3 CFs = $200;
Years 4 and 5 CFs = $300.
The required discount rate is 7%
6.14
6.15
1 - 1+ r t
=C
1+ r
FVOrdinary = C
Annuity
Where:
PV = Present Value
FV = Future Value
C = the equal periodic cash flow
R = interest or discount rate
t = the number of time periods
6.16
1 r
Due
1+ r
FVAnnuity = C
Due
1 r
6.17
6.18
Annuity Example 1
After carefully going over your budget, you have determined
that you can afford to pay $632 per month towards a new
sports car. Your bank will lend to you at 1% per month for 48
months. How much can you borrow?
Formula Approach
Calculator Approach
1- 1+ r -t
632
PMT
PV = Pmt
0
FV
48
N
1- 1.01 -48
= 632
1
I/Y
.01
PV
$23,999.54
= 23,999.54
6.19
1 1 r t
PMT
1 1.05 30
333,333.33
.
05
$5,124,150.29
Calculator Approach
333,333.33
PMT
0
FV
30
N
5
I
PV
$5,124,150.29
6.20
6.21
6.22
1 1 r t
PMT
Calculator Approach
20,000
PV
0
FV
4 x 12 =
N
8 12 =
I
PMT
$488.26
.08
1
12
20,000 PMT
.08
12
PMT $488.26
4 x12
6.23
6.24
6.25
1 1 r t
PMT
1 1.015 t
1,000 20
.
015
1 1.015 t
50
.
015
0.75 1 1.015
0.25 1.015
Calculator Approach
1,000
PV
0
FV
20 +/PMT
1.5
I
N
93.11 months
ln 0.25 t ln 1.015
t 93.11 months or 7.76 years
6.26
1 1 r t
PMT
1 1.05 t
2,000 734.42
.
05
1 1.05 t
2.72
.
05
0.1362 1 1.05
0.8638 1.05
ln 0.8638 t ln 1.05
t 3.0 years
Calculator Approach
2,000
PV
0
FV
734.42 +/PMT
5
I
N
3 years
6.27
6.28
6.29
6.30
1 r t 1
PMT
1.075 40 1
2,000
.
075
454,513.04
Calculator Approach
2,000
PMT
0
PV
40
N
7.5
I
FV
$454,513.04
6.31
FVAnnuity
Due
1 r t 1
PMT
1 r
r
1.08 3 1
10,000
1.08
.08
$35,061.12
Calculator Approach
2nd BGN
10,000
PMT
0
PV
3
N
8
I
FV
$35,061.12
6.32
Perpetuity
Perpetuity: A stream of cash flows that continues
forever
PVPerpetuity =
C1
r
Where:
PV = Present Value
C = the equal periodic cash flow, starting at time period 1
r = discount rate
6.33
Perpetuity Example 1
The Home Bank of Canada want to sell
preferred stock at $100 per share. A very
similar issue of preferred stock already
outstanding has a price of $40 per share and
offers a dividend of $1 every quarter. What
dividend would the Home Bank have to offer
if its preferred stock is going to sell?
6.34
PVPer
PVPer
6.35
Growing Perpetuity
The perpetuities discussed so far are annuities with constant
payments
Growing perpetuities have cash flows that grow at a
constant rate and continue forever
Growing perpetuity formula:
PVPerpetuity
With Growth
C1
rg
6.36
C1
PV
rg
$3.00
0.11 0.06
$60.00
6.37
Growing Annuity
Growing annuities have a finite number of cash
flows, which grow at a constant rate
The formula for a growing annuity is:
C1
PV
rg
1 g
1
1 r
6.38
1
r g
1 r
$50,000
1.05
1
0.08 0.05
1.08
$1,126,571
40
6.39
6.40
6.41
6.42
6.43
6.44
Things to Remember
You ALWAYS need to make sure that the
compounding period and the payment period
match.
If payments are annual, then you use annual
compounding.
If payments are monthly, then you use monthly
compounding
6.45
EAR 1
m
6.46
Decisions, Decisions II
You are comparing two savings accounts. One pays
5.25%, compounded daily. The other pays 5.3%,
compounded semi-annually. Which account would
you use?
First account:
EAR = (1 + .0525/365)365 1 = 5.39%
Second account:
EAR = (1 + .053/2)2 1 = 5.37%
6.47
Second Account:
Semiannual rate = .053 / 2 = .0265
FV = 100(1.0265)2 = 105.37, OR,
2 N; 5.3 / 2 = 2.65 I/Y; 100 PV; CPT FV = 105.37
6.48
R Nom
m (1 EAR) m - 1
6.49
APR Example 1
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?
RNom
m (1 EAR) m 1
12 (1 .12) 12 1
6.50
0
FV
r
2 x 12 =
N
12 x 2
.169
16.9 12 = I
1 1
12
3,500 PMT
PMT
$172.88
0.169
PMT $172.88
12
6.51
FVAnnuity PMT
r
1
m
r
m
Calculator Approach
50
PMT
0
PV
35 x 12 =
N
9 12 =
I
FV
$147,089.22
mt
12 x 35
.09
1
12
0.09
12
50
$147,089.22
6.52
Mortgages
In Canada, financial institutions are required by law
to quote mortgage rates with semi-annual
compounding
Since most people pay their mortgage either monthly
(12 payments per year), semi-monthly (24
payments), bi-weekly (26 payments), or weekly (52
payments), you need to remember to convert the
interest rate before calculating the mortgage
payment!
Remember, the payment period and the compounding
period must always be the same.
6.53
6.54
Mortgages Example 1
Theodore D. Kat is applying to his friendly,
neighbourhood bank for a mortgage of $200,000.
The bank is quoting 6%. He would like to have a 25year amortization period and wants to make
payments monthly. How much are Theodores
monthly payments?
6.55
Mortgage Example 1
Step #1: Calculate EAR
RNom
EAR 1
m
0.06
1
2
6.09%
1
2
m (1 EAR) m - 1
12 (1 .0609) 12 - 1
5.926346%
6.56
Mortgage Example 1
Step #3: Calculate the monthly interest rate by dividing the
answer from Step #2 by the number of payments per year
RMonthly
RNom
# of payments per year
5.926346%
12
0.493862% per month
6.57
Mortgage Example 1
Complete the problem by solving for the monthly payment,
using the annuity formula
Formula Approach
1 1 r t
PVAnnuity PMT
1 1.004938622 12 x 25
200,000 PMT
.
004938622
PMT $1,279.61
Calculator Approach
200,000
PV
0
FV
25 x 12 =
N
0.4938622
I
PMT
$1,279.61
6.58
Continuous Compounding
Sometimes investments or loans are calculated based
on continuous compounding
EAR = er 1
e is the base of the natural logarithms, equal to 2.7183
(although it is actually a non-terminating, non-repeating
decimal)
e is shown on most calculators ex
6.59
6.60
6.61
Summary 6.5
You should know how to:
Calculate PV and FV of multiple cash flows
Calculate payments
Calculate PV and FV of regular annuities,
annuities due, growing annuities, perpetuities, and
growing perpetuities
Calculate EARs and effective rates
Calculate mortgage payments