Financial Management

Session -2
Discounted cash flow valuation

Time Value of Money

Would you prefer to have $1 million now or $1
million 10 years from now?
Of course, we would all prefer the money now!
This illustrates that there is an inherent monetary
value attached to time.
A dollar received today is worth more than a dollar
received tomorrow
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Time Value of Money

TVM is a recognition that money received
today is worth more than an equal amount of
money received months or years in the future:
Why TIME is such an important element in
decision?
This is because a dollar received today can be invested
to earn interest

Cash flows for the future are uncertain

Time Value of Money

Year 1

Year 2

Year 3

500

300

100

100

300

500

300

300

300

Any of the above as they all add up to 900

which one of the above cash flows would you

prefer and why?
Assume that annual interest rate is 10%.
4

Time Value of Money

Discounting Technique
Translating a future cash flow or value into its equivalent
value in a prior period is referred to as discounting.
Used to estimate the present value of money

Compounding Technique
Translating a current value into its equivalent future value
is referred to as compounding.
Used to estimate the future value (FV) of money

Time Value of Money

TVM, is a concept that is frequently used in all
aspects of finance including:

Bond valuation
Stock valuation
Accept/reject decisions for project management
Financial analysis of firms

PV & FV
If you were to invest $10,000 at 5% interest for one
year, your investment would grow to $10,500.
In the one-period case, the formula for FV can be
written as:

FV = C0(1 + r)
Where C0 is cash flow today (t=0), and r is the
appropriate interest rate.

PV & FVContd

In one-period case, the formula for PV can be

written as:
C1
PV
1 r

Where C1 is cash flow at date 1, and r

is the appropriate interest rate.
8

FV for Multi-Period
The general formula for the future value of an
investment over many periods can be written
as:
FV = C0(1 + r)T
Where
C0 is cash flow at t = 0,
r is the appropriate interest rate, and

T is the number of periods over which the cash is

invested (investment horizon).

Exercise: FV
Suppose a stock currently pays a dividend of $1.10,
which is expected to grow at 40% per year for the
next five years.
Estimate the expected dividend after five years?
FV = C0(1 + r)T
= $1.10(1.40)5
= $5.92

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Example: FV

Assume Joe has the following cash flow stream

from his investment.
She wants to know what it will be worth at the end
of the fourth year
$100

0
i = 10%

$300

$500

$1000

4
$1000
?
?

?
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Example: PV

What is the PV of the following cash flow stream?

i=10%

$100

$300

3
$300

4
-$50

90.91
247.93
225.39
-34.15
$530.08 = PV
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Periodic Compounding
Compounding an investment m times a year for T years

FV C0 1
m

mT

If you invest $100 for 3 years at 12% compounded

semi-annually, what amount will you expect at the
end of 3 years?

.12
FV $100 1

23

$100 (1.06) $141.85

6

13

Continuous Compounding
The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C0erT
Where
C0 is cash flow at t = 0,
r is the annual interest rate,
T is the number of years, and
e is a transcendental number approximately equal to
2.718.
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The Power of Compound Interest

A 20-year-old student saves $3 a day for her retirement.
Every day she places $3 in a drawer.
At the end of the year, she invests the accumulated
savings ($1,095) in a brokerage account with an expected
annual return of 12%.
How much money will she have when she is 65 years
old?
If she sticks to her plan, she will have $1,487,262 at the age of
65.

What if she sticks to the plan but returns are compounded

daily?
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The Power of Compound InterestContd

If you dont start saving until you are 40 years old,
how much will you have at 65?
If a 40-year-old investor begins saving today, and
sticks to the plan, he or she will have $146,001 at the
age 65. This is $1.343 million less than if starting at
age 20.
Lesson: It pays to start saving early.

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The Power of Compound InterestContd

How much the 40-year old should deposit annually to
catch the 20-year old?
To find the required annual contribution, enter the
number of years until retirement and the final goal of
$1,487,261.89, and use PMT function in excel or goal
seek.
Otherwise use annuity formula.

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The Power of Compound InterestContd

If you invest $1000 for a year @10% rate of annual
interest, what will be the value after the end of the
year, if interest is compounded yearly, half-yearly,
Quarterly.
Future value
Frequency No.
1100
1
Yearly
1102.5
2
Half-yly
1103.81
4
Qtly
1104.71
12
Monthly
1105.06
52
Weekly
1105.16
365
Daily
1105.17
Continuous
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Simplifications
Perpetuity
A constant stream of cash flows that lasts forever

Growing perpetuity
A stream of cash flows that grows at a constant rate forever

Annuity
A stream of constant cash flows that lasts for a fixed
number of periods

Growing annuity
A stream of cash flows that grows at a constant rate for a
fixed number of periods

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Perpetuity
A constant stream of cash flows that lasts forever

C
C
C
PV

2
3
(1 r ) (1 r ) (1 r )
C
PV
r
20

Exercise: Perpetuity
What is the value of a bond that promises to pay 15
every year for ever?
The interest rate is 10-percent.

15

15

15

15
PV
150
.10
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Growing Perpetuity
A growing stream of cash flows that lasts forever

C(1+g)

C (1+g)2

C
C (1 g ) C (1 g )
PV

2
3
(1 r )
(1 r )
(1 r )
2

C
PV
rg
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Exercise: Growing Perpetuity

The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever. If the
discount rate is 10%, what is the value of this
promised dividend stream?
$1.30
0

$1.30(1.05)
2

$1.30 (1.05)2

$1.30
PV
$26.00
.10 .05
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Annuity
A constant stream of cash flows with a fixed maturity

C
C
C
C
PV

2
3
T
(1 r ) (1 r ) (1 r )
(1 r )
C
1
PV 1
T
r (1 r )
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Exercise: Annuity
If you can afford a $400 EMI for car loan, how much
car loan can you afford if interest rates are 7% for 36month?
$400

$400

$400

$400

36

$400
1
PV
1
$12,954.59

36
.07 / 12 (1 .07 12)
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Exercise: AnnuityContd
What is the present value of a four-year annuity of
$100 per year that makes its first payment two years
from today if the discount rate is 9%?
4

PV1
t 1

$297.22

$100
$100
$100
$100
$100

$323.97
t
1
2
3
4
(1.09) (1.09) (1.09) (1.09) (1.09)

$323.97

$100

$323.97
PV
$297.22
0
1.09

$100

$100

$100

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Exercise: AnnuityContd
Whats the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?

Payments occur annually, but compounding occurs

every 6 months.
Cannot use normal annuity valuation techniques.

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Exercise: AnnuityContd
Whats the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?
0

5%

100

100

100
110.25
121.55
331.80

FV3 = $100(1.05)4 + $100(1.05)2 + $100

FV3 = $331.80
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Growing Annuity
A growing stream of cash flows with a fixed maturity

C(1+g)

C (1+g)2

C(1+g)T-1

C
C (1 g )
C (1 g )
PV

2
T
(1 r )
(1 r )
(1 r )

T 1

1 g
C

PV
1
r g (1 r )

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Exercise: Growing Annuity

A defined-benefit retirement plan offers to pay
$20,000 per year for 40 years and increase the annual
payment by 3% each year. What is the present value
of payments if the discount rate is 10%?
$20,000

$20,000(1.03) $20,000(1.03)39

40

40

$20,000
1.03
PV
$265,121.57
1
.10 .03 1.10
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Exercise: Growing Annuity

You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?

$8,500 (1.07) 2
$8,500 (1.07) 4
$8,500 (1.07)
$8,500 (1.07)3
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

0
1
$34,706.26

5
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What Is a Firm Worth?

Conceptually, a firm should be worth the present
value of its future cash flow.
The tricky part is determining the future CF, timing of
the futue CF, and risk of those cash flows.

32

Problem 26 (Ross 10th Ed)

Mark has been working on an advanced
technology in laser eye surgery. His technology
will be available in the near term. He anticipates
his first annual CF from technology to be
175,000$ received two years from today.
Subsequent annual CF will grow at 3.5% in
perpetuity. What is the PV of the technology if
the discount rate is 10%.

Problem 37 (Ross 10th Ed)

You want to borrow $65000 from your local
bank to buy a new sailboat. You can afford to
make monthly payments of $1320, but no more.
Assuming monthly compounding, what is the
highest APR you can afford on a 60 month loan?

Problem 38 (Ross 10th Ed)

You need a 30 year fixed rate mortgage to buy a
new home for $250,000. Your mortgage bank
will lend you the money at a 5.3% APR for 360
month loan. However, you can only afford
monthly payments of $950, so you offer to pay
off any remaining loan balance at the end of the
loan in the form of a single balloon payment.
How large will this balloon payment have to be
for you to keep your monthly payments at $950?

Problem 46 (Ross 10th Ed)

Given an interest rate of 6.1% per year, what is
the value at date t = 7 of a perpetual stream of
$2,500 annual payments that begin at date t =
15?

Problem 51 (Ross 10th Ed)

You want to lease a set of golf clubs from Pings
Ltd. The lease contract is in the form of 24 equal
monthly payments at a 10.4% stated annual
interest rate compounded monthly. Because the
clubs cost $2300 retail, Pings Ltd. want the PV
of lease payments to equal $2300. Suppose that
your first payment is due immediately. What will
your monthly lease payments be?

Problem 53 (Ross 10th Ed)

Tom Adams has received a job offer from a large
investment bank as a clerk to an associate banker.
His base salary will be $55,000. He will receive his
first annual salary payment one year from the day he
begins to work. In addition, he will get an
immediate $10,000 bonus for joining the company.
His salary will grow at 3.5 percent each year. Each
year he will receive a bonus equal to 10 percent of
his salary. Mr. Adams is expected to work for 25
years. What is the present value of the offer if the
discount rate is 9 percent?

Thank You!

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