Chapter

Six
Discounted Cash
Flow Valuation

2003 The McGraw-Hill Companies, Inc. All rights

6.2

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

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

Multiple Cash Flows 6.1 FV Example 1

You currently have $7,000 in a bank account earning 8%
interest. You think you will be able to deposit an additional
$4,000 at the end of each of the next three years. How much
will you have in three years?
0

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

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?
0

500

600

2
654.00
594.05
$1,248.05

9%

6.6

Multiple Cash Flows FV Example 2 Continued

Using the cash flows from the previous page, how much will
you have at the end of 5 years, if you were to make no further
deposits?
0

500

600

9%

846.95
769.31
$ 1,616.26

6.7

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%?
0

1
100

3
300

8%

349.92
136.05
$ 485.97

6.8

Multiple Cash Flows PV Example 1

You are offered an investment that will pay you $200 in one
year, $400 the next year, $600 the year after, and $800 at the
end of the following year. You can earn 12% on similar
investments. How much is this investment worth today?
0

200

400

600

800

178.57
318.88
427.07
508.41
1,432.93

PV

FV

1 r

12%

6.9

Multiple Cash Flows PV Example 2

You are considering an investment that will pay you $1000 in
one year, $2000 in two years and $3000 in three years. If you
want to earn 10% on your money, how much would you be
willing to pay?

Answer:
$4,815.93

6.10

Multiple Cash Flows Using a Spreadsheet

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

6.11

Uneven Cash Flows Using the Calculator

Another way to use the financial calculator for uneven cash
flows is to use the cash flow keys
HP 10BII
Enter the first cash flow, using the +/- keys to indicate
outflows
Press CF
Enter the second cash flow
Press CF
Enter the interest rate as I/Y
Use the 2nd function, then the NPV key to compute the
present value
To clear this function, use 2nd function, Clear All

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

Reject: NPV < 0

rule is to accept only projects with an

NPV > 0

6.13

Quick Quiz Part I

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?
What is the value of the cash flows at year 3?

6.14

Annuities and Perpetuities 6.2

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

6.15

Annuities Basic Formulas

Annuities:
PVOrdinary
Annuity

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

Ordinary Annuities Versus Annuities Due

Ordinary Annuity first payment occurs at
time period 1
Annuity Due first payment occurs at time
period 0
1 - 1+ r) t
PVAnnuity = C

1 r
Due

1+ r

FVAnnuity = C
Due

1 r

6.17

Annuities and the Calculator

To solve any annuity type problem using the function
keys, you must use the PMT key
Only use the PMT key when each cash flow is exactly the
same size and occurs at regular intervals

Ordinary annuity versus annuity due

To switch the calculator between an ordinary annuity and
an annuity due, enter 2nd BGN (HP 10BII)
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

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

Annuity Sweepstakes Example

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?
Formula Approach
PV Annuity

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

Annuities on the Spreadsheet - Example

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

6.21

Quick Quiz Part II

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 expect to earn 9 per year,
compounded monthly and you expect to need
the income for 25 years, how much do you
need to have in your account at retirement?

6.22

Finding the Payment

Suppose you want to borrow $20,000 for a new car. You can
borrow at 8% per year, compounded monthly (8%/12 =
0.66667% per month). If you take a 4 year loan, what is
your monthly payment?
Formula Approach
PVAnnuity

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

Finding the Payment on a Spreadsheet

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

6.24

Finding the Number of Payments Example 1

You ran a little short on your February vacation, so
you put $1,000 on your credit card. You can only
afford to make the minimum payment of $20 per
month. The interest rate on the credit card is 1.5%
per month. How long will you need to pay off the
$1,000?

6.25

Finding the Number of Payments Example 1

Formula Approach
Start with the basic annuity formula and solve for the
unknown exponent t, using logs.
PVAnnuity

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

Finding the Number of Payments Example 2

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?
PVAnnuity

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

Finding the Rate On the Financial Calculator

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?
Calculator Approach
10,000
PV
0
FV
207.58 +/PMT
60
N
I
0.7499% per month

6.28

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

6.29

Quick Quiz Part III

You want to receive $5000 per month for the next 5 years.
How much would you need to deposit today if you can earn
0.75% 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 0.75%
per month.
How many months could you receive the $5000 payment?
How much could you receive every month for 5 years?

6.30

Future Values for Annuities Example 1

Suppose you begin saving for your retirement by depositing
$2000 per year in an RRSP. If the interest rate is 7.5%, how
much will you have in 40 years?
Formula Approach
FVAnnuity

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

Annuity Due Example 1

You are saving for a new house and you put $10,000 per year in an account paying 8% compounded
annually. The first payment is made today. How much will you have at the end of 3 years?
Formula Approach

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

Perpetuity Example 1 continued

First, find the required return for the comparable issue:
C1
r
$1.00
40
r
r 2.5% per quarter

PVPer

Then, using the required return found above, find the

dividend for new preferred issue:
C1
r
C1
100
0.025
C1 $2.50 per quarter

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

Growing Perpetuity Example 1

Hoffstein Corporation is expected to pay a dividend of $3
per share next year. Investors anticipate that the annual
dividend will rise by 6% per year forever. The required
rate of return is 11%. What is the price of the stock today?

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

Growing Annuity Example 1

Gilles Lebouder has just been offered a job paying $50,000
at the end of his first year. He anticipates his salary will
then increase by 5% a year until his retirement in 40 years.
Given an interest rate of 8%, what is the present value of his
lifetime salary?
C1
1 g
PV

1
r g
1 r

$50,000
1.05

1
0.08 0.05
1.08
$1,126,571

40

6.39

Quick Quiz Part IV

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?

6.40

Work the Web Example

Another online financial calculator can be found at
MoneyChimp
Click on the web surfer and work the following
example
Choose calculator and then annuity
You just inherited $5 million. If you can earn 6% on your
money, how much can you withdraw each year for the next
40 years?
Datachimp assumes an annuity due!!!
Payment = $313,497.81

6.41

Effective Annual Rate (EAR) 6.3

The Effective Annual Interest Rate is the actual rate
paid (or received) after accounting for compounding
that occurs during the year
For example, 10% compounded twice a year has an
EAR of 10.25%. This means that 10%, compounded
twice a year, is identical to 10.25%, compounded
annually.
If you want to compare two alternative investments
with different compounding periods, you need to
compute the EAR for both investments and then
compare the EARs.

6.42

Annual Percentage Rate (Nominal Rate)

This is the annual rate that is quoted by law
By definition, the nominal rate or APR =
period rate times the number of periods per
year
Consequently, to get the period rate we
rearrange the APR equation:
Period rate = APR / number of periods per year

You should NEVER divide the effective rate

by the number of periods per year it will
NOT give you the period rate

6.43

Computing APRs (Nominal Interest Rate)

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%

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

Calculating EARs Example 1

To calculate the EAR, use the following formula:
R Nom

EAR 1
m

For example, the EAR for 10% is:

Compounding Periods EAR
2 10.25%
4 10.3813%
12 10.4713%
52 10.5065%
365 10.5156%

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%

You should choose the first account (the account that

compounds daily), because you are earning a higher
effective interest rate.

6.47

Decisions, Decisions II Continued

Lets 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, OR,
365 N; 5.25 / 365 = .014383562 I/Y; 100 PV; CPT FV = 105.39

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

You have more money in the first account.

6.48

Computing APRs from EARs

If you have an effective rate, how can you compute
the APR? Rearrange the EAR equation and you get:

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

.113 8655152 or 11.39%

6.50

Computing Payments with APRs Example 1

Suppose you want to buy a new computer system and the store
is willing to 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?
Formula Approach
Calculator Approach
3,500
PV
1 1 r t
PVAnnuity PMT

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

Future Values with Monthly Compounding

Suppose you deposit $50 a 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?
Formula Approach

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

The Three Step Process

Whenever you are faced with a situation when the payment
period and the compounding period are not equal, you can
apply the Three Step Process to solve the problem.
Step #1: Calculate the Effective Annual Interest Rate, using
the number of compounding periods per year
Step #2: Calculate a new notional nominal rate (APR), using
the number of payment periods per year
Step #3: Calculate the per period interest rate by dividing the
answer from Step #2 by the number of payments per year

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

Step #2: Calculate the new notional nominal rate

R Nom

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

Example: What is the effective annual rate of 7%

compounded continuously?
EAR = e.07 1 = .0725 or 7.25%

6.59

Quick Quiz Part V

What is the definition of an APR or nominal
rate?
What is the effective annual rate?
Which rate should you use to compare
alternative investments or loans?

6.60

Work the Web Example

There are web sites available that can easily
provide you with information on home buying
and mortgages
Click on the web surfer to check out the
Canadian Mortgage and Housing Corporation
site

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