Discounted Cash Flow

Valuation
BASIC PRINCIPAL
Would you rather have $1,000 today or
$1,000 in 30 years?
Why?

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Present and Future Value
Present Value: value of a future payment today
Future Value: value that an investment will
grow to in the future
We find these by discounting or compounding
at the discount rate
Also know as the hurdle rate or the opportunity
cost of capital or the interest rate

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One Period Discounting
PV = Future Value / (1+ Discount Rate)
V0 = C1 / (1+r)
Alternatively
PV = Future Value * Discount Factor
V0 = C1 * (1/ (1+r))
Discount factor is 1/ (1+r)

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PV Example
What is the value today of $100 in one year, if
r = 15%?

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FV Example
What is the value in one year of $100, invested
today at 15%?

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Discount Rate Example
Your stock costs $100 today, pays $5 in
dividends at the end of the period, and then
sells for $98. What is your rate of return?
PV =
FV =

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NPV
NPV = PV of all expected cash flows
Represents the value generated by the project
To compute we need: expected cash flows &
the discount rate
PositiveNPV investments generate value
Negative NPV investments destroy value

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Net Present Value (NPV)
NPV = PV (Costs) + PV (Benefit)
Costs:are negative cash flows
Benefits: are positive cash flows
One period example
NPV = C0 + C1 / (1+r)
For Investments C0 will be negative, and C1 will be
positive
For Loans C0 will be positive, and C1 will be
negative
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Net Present Value Example
Suppose you can buy an investment that
promises to pay $10,000 in one year for
$9,500. Should you invest?

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Net Present Value
Sincewe cannot compare cash flow we
need to calculate the NPV of the
investment
If the discount rate is 5%, then NPV is?

At what price are we indifferent?

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Coffee Shop Example
If you build a coffee shop on campus, you can
sell it to Starbucks in one year for $300,000
Costs of building a coffee shop is $275,000

Should you build the coffee shop?

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Step 1: Draw out the cash flows

Today Year 1

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Step 2: Find the Discount Rate
Assume that the Starbucks offer is guaranteed
US T-Bills are risk-free and currently pay 7%
interest
This is known as rf
Thus, the appropriate discount rate is 7%
Why?

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Step 3: Find NPV
The NPV of the project is?

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If we are unsure about future?
Whatis the appropriate discount rate if
we are unsure about the Starbucks offer
rd = rf
rd > rf
rd < rf

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The Discount Rate
Should take account of two things:
1. Time value of money
2. Riskiness of cash flow
The appropriate discount rate is the
opportunity cost of capital
This is the return that is offer on comparable
investments opportunities

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Risky Coffee Shop
Assume that the risk of the coffee shop is
equivalent to an investment in the stock
market which is currently paying 12%

Should we still build the coffee shop?

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Calculations
Need to recalculate the NPV

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Future Cash Flows
Since future cash flows are not certain, we
need to form an expectation (best guess)
Need to identify the factors that affect cash flows
(ex. Weather, Business Cycle, etc).
Determine the various scenarios for this factor (ex.
rainy or sunny; boom or recession)
Estimate cash flows under the various scenarios
(sensitivity analysis)
Assign probabilities to each scenario

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Expectation Calculation
The expected value is the weighted average of
Xs possible values, where the probability of
any outcome is p
E(X) = p1X1 + p2X2 + . psXs
E(X) Expected Value of X
Xi Outcome of X in state i
pi Probability of state i
s Number of possible states
Note that = p1 + p2 +.+ ps = 1
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Risky Coffee Shop 2
Now the Starbucks offer depends on the state
of the economy

Recession Normal Boom

Value 300,000 400,000 700,000
Probability 0.25 0.5 0.25

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Calculations
Discount Rate = 12%
Expected Future Cash Flow =

NPV =

Do we still build the coffee shop?

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Valuing a Project Summary
Step 1: Forecast cash flows
Step 2: Draw out the cash flows
Step 3: Determine the opportunity cost of
capital
Step 4: Discount future cash flows
Step 5: Apply the NPV rule

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Reminder
Important to set up problem correctly
Keep track of
Magnitude and timing of the cash flows
TIMELINES
You cannot compare cash flows @ t=3 and @
t=2 if they are not in present value terms!!

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General Formula
PV0 = FVN/(1 + r)N OR FVN = PVo*(1 + r)N

Given any three, you can solve for the fourth

Present value (PV)
Future value (FV)
Time period
Discount rate

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Four Related Questions
1. How much must you deposit today to have $1
million in 25 years? (r=12%)
2. If a $58,823.31 investment yields $1 million in 25
years, what is the rate of interest?
3. How many years will it take $58,823.31 to grow to
$1 million if r=12%?
4. What will $58,823.31 grow to after 25 years if
r=12%?

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FV Example
Suppose a stock is currently worth $10, and is
expected to grow at 40% per year for the next five
years.
What is the stock worth in five years?
$10

0 1 2 3 4 5

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PV Example
How much would an investor have to set aside
today in order to have $20,000 five years from
now if the current rate is 15%?
PV $20,000

0 1 2 3 4 5

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Historical Example
From Fibonaccis Liber Abaci, written in the year
1202: A certain man gave 1 denari at interest so that
in 5 years he must receive double the denari, and in
another 5, he must have double 2 of the denari and
thus forever. How many denari from this 1denaro
must he have in 100 years?
What is rate of return? Hint: what does the investor
earn every 5 years

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Simple vs. Compound Interest
Simple Interest: Interest accumulates only on
the principal
Compound Interest: Interest accumulated on the
principal as well as the interest already earned
What will $100 grow to after 5 periods at 35%?
Simple interest
FV = (PV * (r) + PV *(r)) + PV = PV (1 + 2r) =
2 0 0 0 0
Compounded interest
FV = PV (1+r) (1+r)= PV (1+r)2 =
2 0 0

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Compounding Periods
We have been assuming that compounding
and discounting occurs annually, this does not
need to be the case

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Non-Annual Compounding
Cash flows are usually compounded over
periods shorter than a year
The relationship between PV & FV when
interest is not compounded annually
FVN = PV * ( 1+ r / M) M*N
PV = FVN / ( 1+ r / M) M*N
M is number of compounding periods per year
N is the number of years

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Compounding Examples
What is the FV of $500 in 5 years, if the
discount rate is 12%, compounded monthly?

What is the PV of $500 received in 5 years, if

the discount rate is 12% compounded
monthly?

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Another Example
An investment for $50,000 earns a rate of
return of 1% each month for a year. How
much money will you have at the end of the
year?

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Interest Rates
The 12% is the Stated Annual Interest Rate
(also known as the Annual Percentage Rate)
This is the rate that people generally talk about
Ex. Car Loans, Mortgages, Credit Cards

However, this is not the rate people earn or

pay
The Effective Annual Rate is what people
actually earn or pay over the year
The more frequent the compounding the higher the
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Effective Annual Rate
Compounding Example 2
If you invest $50 for 3 years at 12%
compounded semi-annually, your investment
will grow to:

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Compounding Example 2: Alt.
If you invest $50 for 3 years at 12%
compounded semi-annually, your investment
will grow to: $70.93
Calculate the EAR: EAR = (1 + R/m)m 1

So, investing at compounded annually

is the same as investing at 12% compounded
semi-annually 38
EAR Example
Find the Effective Annual Rate (EAR) of an 18% loan
that is compounded weekly.

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Credit Card
A bank quotes you a credit card with an interest rate
of 14%, compounded daily. If you charge $15,000 at
the beginning of the year, how much will you have to
repay at the end of the year?
EAR =

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Credit Card
A bank quotes you a credit card with an interest rate
of 14%, compounded daily. If you charge $15,000 at
the beginning of the year, how much will you have to
repay at the end of the year?
EAR =

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Present Value Of a Cash Flow Stream

C1 C2 C3 CN
PV = + + +...+
(1 + r1 ) (1 + r2 ) (1 + r3 )
2 3
(1 + rN ) N

N
Ct
=
t =1 (1 + rt ) t

Discount each cash flow back to the present

using the appropriate discount rate and then
sum the present values.

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Insight Example
r = 10%
Year Project A Project B
1 100 300
2 400 400
3 300 100

PV

Which project is more valuable? Why?

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Various Cash Flows
A project has cash flows of $15,000, $10,000, and
$5,000 in 1, 2, and 3 years, respectively. If the
interest rate is 15%, would you buy the project if it
costs $25,000?

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Example (Given)
Consider an investment that pays $200 one
year from now, with cash flows increasing by
$200 per year through year 4. If the interest
rate is 12%, what is the present value of this
stream of cash flows?
If the issuer offers this investment for $1,500,
should you purchase it?

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Multiple Cash Flows (Given)
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93

Dont buy
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 Various Cash Flow (Given)
A project has the following cash flows in periods 1
through 4: $200, +$200, $200, +$200. If the prevailing
interest rate is 3%, would you accept this project if you
were offered an up-front payment of $10 to do so?
PV = $200/1.03 + $200/1.032 $200/1.033 + $200/1.034
PV = $10.99.
NPV = $10 $10.99 = $0.99.
You would not take this project

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Common Cash Flows Streams
Perpetuity, Growing Perpetuity
A stream of cash flows that lasts forever
Annuity, Growing Annuity
A stream of cash flows that lasts for a fixed
number of periods
NOTE: All of the following formulas assume the
first payment is next year, and payments occur
annually

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Perpetuity
A stream of cash flows that lasts forever
C C C

0 1 2 3
C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

PV: = C/r
What is PV if C=$100 and r=10%:

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Perpetuity Example
What is the PV of a perpetuity paying $30
each month, if the annual interest rate is a
constant effective 12.68% per year?

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Perpetuity Example 2
What is the prevailing interest rate if a
perpetual bond were to pay $100,000 per year
beginning next year and costs $1,000,000
today?

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Growing Perpetuities
Annual payments grow at a constant rate, g
C1 C2(1+g) C3(1+g)2

0 1 2 3

PV= C1/(1+r) + C1(1+g)/(1+r)2 + C1(1+g)2(1+r)3 +

PV = C1/(r-g)
What is PV if C1 =$100, r=10%, and g=2%?

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Growing Perpetuity Example
What is the interest rate on a perpetual bond that pays
$100,000 per year with payments that grow with the
inflation rate (2%) per year, assuming the bond costs
$1,000,000 today?

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Growing Perpetuity: Example (Given)
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(1.05) $1.30 (1.05) 2
$1.30 = $1.43
= $1.37

0 1 2 3

PV = 1.30 / (0.10 0.05) = $26

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Example
An investment in a growing perpetuity costs
$5,000 and is expected to pay $200 next year.
If the interest is 10%, what is the growth rate
of the annual payment?

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Annuity
A constant stream of cash flows with a fixed maturity

C C C C

0 1 2 3 T

C C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) T

C 1
PV = 1 T
r (1 + r )
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 Annuity Formula
C
C
PV = r T
r (1 + r )
C C C C C C C

0 1 2 3 T T+1 T+2 T+3

Simply subtracting off the PV of the rest of the

perpetuitys cash flows
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Annuity Example 1
Compute the present value of a 3 year ordinary
annuity with payments of $100 at r=10%
Answer:

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Alternative: Use a Financial Calculator
Texas Instruments BA-II Plus, basic
N = number of periods
I/Y = periodic interest rate
P/Y must equal 1 for the I/Y to be the periodic rate
Interest is entered as a percent, not a decimal
PV = present value
PMT = payments received periodically
FV = future value
Remember to clear the registers (CLR TVM) after each
problem
Other calculators are similar in format

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 Annuity Example 2
You agree to lease a car for 4 years at $300 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of
capital is 0.5% per month, what is the cost of the lease?
Work through on your financial calculators

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Annuity Example 3
What is the value today of a 10-year annuity
that pays $600 every other year? Assume that
the stated annual discount rate is 10%.
What do the payments look like?

What is the discount rate?

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Annuity Example 3
What is the value today of a 10-year annuity
that pays $600 every other year? Assume that
the stated annual discount rate is 10%.
What do the payments look like?
PV $600 $600 $600 $600 $600

0 2 4 6 8 10

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Annuity Example 3
What is the value today of a 10-year annuity
that pays $600 every other year? Assume that
the stated annual discount rate is 10%.
What is the discount rate?

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Annuity Example 4
What is the present value of a four payment
annuity of $100 per year that makes its first
payment two years from today if the discount
rate is 9%?
What do the payments look like?

0 1 2 3 4 5

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Annuity Example 5
What is the value today of a 10-pymt annuity
that pays $300 a year if the annuitys first
cash flow is at the end of year 6. The interest
rate is 15% for years 1-5 and 10% thereafter?

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Annuity Example 5
What is the value today of a 10-pymt annuity that
pays $300 a year (at year-end) if the annuitys first
cash flow is at the end of year 6. The interest rate is
15% for years 1-5 and 10% thereafter?
Steps:
1. Get value of annuity at t= 5 (year end)

2. Bring value in step 1 to t=0

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Annuity Example 6
You win the $20 million Powerball. The lottery
commission offers you $20 million dollars today or
a nine payment annuity of $2,750,000, with the first
payment being today. Which is more valuable is
your discount rate is 5.5%?

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Alt: Annuity Example 6
You win the $20 million Powerball. The lottery
commission offers you $20 million dollars today or
a nine payment annuity of $2,750,000, with the first
payment being today. Which is more valuable if
your discount rate is 5.5%?

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Delayed first payment: Perpetuity
What is the present value of a growing
perpetuity, that pays $100 per year, growing at
6%, when the discount rate is 10%, if the first
payment is in 12 years?

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Growing Annuity
A growing stream of cash flows with a fixed maturity

C C(1+g) C (1+g)2 C(1+g)T-1

0 1 2 3 T
T 1
C C (1 + g ) C (1 + g )
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) T

C 1+ g
T

PV = 1
r g (1 + r )
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Growing Annuity: Example
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 at retirement if the discount rate
is 10%?

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

0 1 2 40

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 Growing Annuity: Example (Given)
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%?

PV = (8,500/(.12-.07)) * [ 1- {1.07/1.12}5] = $34,706.26

0 1 2 3 4 5

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Growing Perpetuity Example
What is the value today a perpetuity that makes
payments every other year, If the first payment is $100,
the discount rate is 12%, and the growth rate is 7%?
r:

g:

Price:

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Valuation Formulas
FVn
PV = FVn = PV * (1 + r ) n
(1 + r ) n

C C1
PV = PV =
rg
r
C 1
PV = 1 1+ g
T
r (1 + r )T PV =
C1
1
r g (1 + r )

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Remember
That when you use one of these formulas or
the calculator the assumptions are that:
PV is right now
The first payment is next year

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What Is a Firm Worth?
Conceptually, a firm should be worth the
present value of the firms cash flows.
The tricky part is determining the size, timing,
and risk of those cash flows.

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Quick Quiz
1. How is the future value of a single cash flow
computed?
2. How is the present value of a series of cash flows
computed.
3. What is the Net Present Value of an investment?
4. What is an EAR, and how is it computed?
5. What is a perpetuity? An annuity?

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Why We Care
The Time Value of Money is the basis for all
of finance
People will assume that you have this down
cold

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