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Discounted Cash-Flow Valuation

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Assumptions till Chapter 14
Markets are Efficient.
Traded price = Current value of asset
No irrational pricing.
Expect to get a return appropriate for the risk taken.
Higher risk, higher expected return.

Frictionless markets
No transactions Costs
No Taxes
No information asymmetry
No regulation
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About the assumptions
In this course, we mostly focus on what should happen if
the frictionless markets assumptions hold (null hypothesis)

Violations of these assumptions is what makes finance
and other business courses important
We will start discussing these when we discuss Capital Structure.

We will emphasize value and price in this course.

Decisions that do not affect value/price are unimportant.

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What is Time Value of Money?
A dollar today is worth more than a dollar tomorrow.
Investors require to be compensated for postponing consumption
and lending the money.
Higher the expected inflation and higher the uncertainty associated
with the lending the higher will be the compensation.

This is very intuitive, but we often misjudge the strength of
compounding.
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Suppose you place $100 in a savings
account that pays a 5% interest per year
(annual compounding).

What will be your balance at the end of Year
1? Year 2? Year 10?
Future Value of a Lumpsum
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Year Beg. Value Interest Ending Value
1 $100 100x 0.05=5 100 + 100 x 0.05
=100 (1+0.05)=105
2 105 105 x 0.05=5.25 105 + 105 x 0.05
=100(1+0.05)
2
=110.25
3 110.25 110.25 x 0.05
=5.5125
110.25 +110.25 x 0.05
=100(1+0.05)
3
=115.7625
.
.
10 155.133 155.13 x 0.05=7.76 100(1+0.05)
10
=162.89
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Future Value of a Lumpsum
In general,
your balance in the future (called Future Value or FV),
n periods from now,
on your investment today (called Present Value or PV)

is given by

FV
n
= PV
0
(1+i)
n
------ (a)

where i is the periodic interest rate.



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Input in Calculator
Before you start,
Make sure you set p/y to 1
Make sure you do not see BGN on your screen
Press 2
nd
and CLR TVM. HP: clear all.

Type 100 and then press PV
Type 5 (not 0.05) and then press I/Y
Type 10 and press N
Type 0 and Press PMT (default is 0, but good practice)
Press FV and then CPT

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Do we misjudge the extent of TVM?
Popular example (Ignore controversy over the estimate):
Peter Minuit bought Manhattan for an estimated value of $24
(60 Dutch Guilders) in 1624. Is this a good deal?

Calculator:
PV=24,
N=387,
I=x%,
PMT=0,
FV=?
Rate Value today
1% $1,128.71
2% $51,106.69
3% $2,229,550
4% $93,780,717
5% $3,806,010,497
6% $149,135,522,178
7% $5,645,900,314,847
8% $206,635,347,617,554
9% $7,315,869,411,998,800
10% $250,715,046,098,361,000
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FV of $1
$0
$20
$40
$60
$80
$100
$120
$140
0 10 20 30 40 50
No. of Years
@ 10%
@ 3%
Calculator: PV=1, N=x years, I=10% or 3%, PMT=0, FV=?
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More Frequent Compounding
Interest rates are often stated on annual basis.
But, compounding periods may be
monthly (for mortgage payments),
quarterly (dividend yield),
or semi-annually (bonds)

When you have multiple compounding periods within a
year, say m, we can rewrite the earlier formula as,

FV
n
= PV
0
(1 + i/m)
mn
------- (b)

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As compounding periods become smaller the FV
increases. But there is a limit to the increase.

As we continue shortening the compounding period, i.e.
as m , (1+i/m)
m
e
i
, where e is the exponential
function, approximated by a value of 2.718.

So, with Continuous compounding

FV
n
= PV
0
x e
in
----- (c)

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Find Future value after 10 years of $100 deposited today if the
stated interest rate is 5% per year, but compounding periods are
different.
Periodic FV after Calculator Input no of periods
Rate 10 years
0.05 $162.89 PV=100, N=10, I=5%, PMT=0, FV=? 162.8895 1
0.025 $163.86 PV=100, N=10*2, I=5/2%, PMT=0, FV=? 163.8616 2
0.0125 $164.36 PV=100, N=10*4, I=5/4%, PMT=0, FV=? 164.3619 4
0.008333333 $164.53 PV=100, N=10*6, I=5/6%, PMT=0, FV=? 164.5309 6
0.004166667 $164.70 PV=100, N=10*12, I=5/12%, PMT=0, FV=? 164.7009 12
0.001923077 $164.79 PV=100, N=10*26, I=5/26%, PMT=0, FV=? 164.793 26
0.000961538 $164.83 PV=100, N=10*52, I=5/52%, PMT=0, FV=? 164.8325 52
0.000136986 $164.87 PV=100, N=10*365, I=5/365%, PMT=0, FV=? 164.8665 365
5.70776E-06 $164.87 PV=100, N=10*8760, I=5/8760%, PMT=0, FV=? 164.8719 8760
Continuous compounding: 100 x e
10x0.05
= $164.87
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Definition
The rate that is used to equate FV and PV is
called the Discount Rate.
1
For bonds, it will be called Yield to Maturity
For stocks, from investor perspective, this will be
called Expected Rate of Return
From the firms perspective, when applied to
projects, it will be called Cost of Capital / Required
rate of return.

1 In finance, we often have alternative definitions for the same term. This is one of them. Discount rate is also
the rate at which banks can borrow short-term funds from the Federal Reserve.
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Value of Cash-Flow Stream
Value is additive. Thus, we can add Present Values.
If a firm pays multiple cash-flows, you can find value of
each cash-flow and add it up, to get value of the asset.
From (a), the present value, PV, of a cash-flow n years
from now using annual compounding is



Thus, the present value of CF
1
in Year 1, CF
2
in Year 2,
, and CF
n
in Year n can be written as




n
n
2
2 1
0
i) (1
CF
.......
i) (1
CF
i) (1
CF
PV
+
+ +
+
+
+
=
n
n
0
i) (1
FV
PV
+
=
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Discounted Cash-flow Valuation
In many practical situations, we will be required to
value the asset today.
To do that, we will project future cash-flows from the
asset, discount these future cash-flows at a discount
rate that is appropriate for the riskiness of the cash-
flows, and find its value today.
Hence the name Discounted Cash-flow Valuation.

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Some simple streams of cash-flow
a. Perpetuity: Equal payments forever
b. Annuity: Equal payments for a finite period
c. Growing Perpetuity: Payments grow at a
constant rate forever
d. Growing Annuity: Payments grow at a constant
rate for a finite period

Initially these look very difficult to value. But, we
use some simple tricks to come up with easy
formulas to value them.
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Value of a Perpetuity
) 1 ......( ..........
) 1 (
.......
) 1 ( ) 1 (
2
0

+
+ +
+
+
+
=
i
P
i
P
i
P
PV
Multiply both sides of the equation by (1+i).
PV i P
P
i
P
i
P
i
( )
( ) ( )
.......
( )
....( ) 1
1 1 1
2
2 1
+ = +
+
+
+
+ +
+

Subtract (1) from (2). Most terms cancel off. We have
PV i PV P ( ) 1+ =
Thus, PV of a perpetuity at time 0 (first cash-flow is at time 1)
i
P
PV =
0
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Value of an annuity
) ......( ..........
) 1 (
.......
) 1 ( ) 1 (
2
0
a
i
P
i
P
i
P
PV
n
+
+ +
+
+
+
=
We can write this as a difference between two perpetuities;
One, a perpetuity starting right now, and another, starting in
period n+1. i.e. we consider the following perpetuities:
) 1 ......( ..........
) 1 (
.......
) 1 ( ) 1 (
2
0

+
+ +
+
+
+
=
i
P
i
P
i
P
PV

We just showed that the value of this perpetuity today is P/i.
) ......(
) 1 (
....
) 1 ( ) 1 (
.......
) 1 ( ) 1 (
1 2
0
b
i
P
i
P
i
zero
i
zero
i
zero
PV
n n +
+
+ +
+
+
+
+ +
+
+
+
=
What is the value of cash-flow stream b? (next slide)

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This is a perpetuity starting at the end of n years. Its
value at that time will be P
n+1
/i. Since this is the value n
periods from now, its value today will be



The value of the annuity is the difference in the value of
these two perpetuities. This equals




You could also solve it in a way similar to valuing a perpetuity.
n
n
i
i
P
) 1 (
1
+
+
n
n
n
i
i
P
i
P
) 1 (
1
1
+

+
+
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Value of a growing Perpetuity / Annuity
The formula for Growing perpetuity and annuity can
be arrived in a similar fashion to the earlier formulas
with one modification. If g is the growth rate, rewrite
as (1+q). Substitute P with C(1+g)

We will get equations very similar to before in q and
C, instead of r and P. Re-substitute for q by r
and C by P in the formula. We get
Value of a growing perpetuity

Value of a growing annuity
) 1 (
) 1 (
g
i
+
+
g i
P
PV

=
1
0
n
i
g
g i
P
g i
P
PV
|
|
.
|

\
|
+
+

=
) 1 (
) 1 (
1 1
0
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Calculating EAR from APR
To compare stated interest rates over different compounding
periods, we compute the Effective Annual Rate (EAR).

EAR is what the stated interest rate (a.k.a. APR) is equivalent
to, if it is compounded annually.

If you invest $1 today, it will grow to $1(1+i/m)
m
in one year.
Return= (End value Begin value)/Begin value = (1+i/m)
m
1 = EAR

In the calculator, PV=$1, N=m, I=I/m%, PMT=0, FV=?

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Major Confusion # 1
What is the difference between EAR, APR,
stated rate and the actual discount rate?

APR is the same as stated rate. You never use it
directly to discount cash-flows.

You divide APR by number of compounding periods per
year to get the periodic discount rate. This is the rate you
will use to discount cash-flows.
The rate used to discount cash-flows for a year is EAR

How long is a compounding period? It is likely the period
between cash-flows.

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Homework 2
Problems 2, 8, 12, 15, 16, 23, 30, 38, 56, 61, 65,
69 and the mini-case in page 134 from Chapter 4
of RWJ, and Q1 from Spring 2009 midterm exam

Homework is due Tuesday, Sep 20, 2011.

Potentially helpful videos:
http://academicearth.org/lectures/financing-math-healthcare
http://www.khanacademy.org/#finance