Chapter 5

Discounted Cash
Flow Valuation

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• Future and Present Values of Multiple
Cash Flows
• Valuing Level Cash Flows: Annuities
and Perpetuities
• Comparing Rates: The Effect of
Compounding Periods
• Loan Types and Loan Amortization

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Time line - Chapter 4

T= 0 1 2 3 4 5
_____________________________________________

PV FV

PV = Present Value
FV = Future Value
t = Numbers of period
r = Interest rate

•Single cash flow: FV=PV(1+r)t

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Time line - Chapter 5

T= 0 1 2 3 4 5
_____________________________________________

CF1 CF2 CF3 CF4 CF5

PV FV
CF1= Cash Flow in Yr1
CF2= Cash Flow in Yr2
CF3= Cash Flow in Yr3
CF4= Cash Flow in Yr4
CF5= Cash Flow in Yr5
•Multiple cash flows valuation: PV or FV
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Uneven Cash Flows – Future Value

Example
• You can deposit $4000 at the end of
the next three years in a bank
account paying 8% interest. You
currently have $7000 in the account.
How much will you have in three
years? In four years?

• Find the future value of each cash

flow and add them together.
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Uneven Cash Flows – Present

Value Example
• You are offered an investment that will pay
you $200 in one year, $400 the next year,
$600 the next year, and $800 at the end of
the next. If you can earned 12%, what is
the most this investment is worth today?

• Find the PV of each cash flow and add them

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Quick Quiz: Part 1

• Suppose you are looking at the following
possible cash flows: Year 1 CF = $100; Years 2
and 3 CFs = $200; Years 4=0 and Year 5 CFs =
$300. The required discount rate is 7%
• What is the value of the cash flows at year 5?
(FV5 = $905.07)
• What is the value of the cash flows today?
(PV= $645.3)
• What is the value of the cash flows at year 3?
(FV3= $790.52)

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Level Cash Flows: Annuities
and Perpetuities
• 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

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Annuities– Basic Formulas

• Annuities (ordinary):
 1 
 1 − 
(1 + r) t
PV =C  
 r 

 

(1 +r) t −1 
FV =C  
 r 
C = equal cash flow (PMT)
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Annuities– Tables
• Annuities (ordinary):
PV = C * PVIFA (r%, t)
App. A3 (pg.584)

FV = C * FVIFA (r%, t)
App. A4 (pg.586)

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Present Value of Annuity

• You won a lottery. The money is paid in
equal annual installments of $100,000 over
3 years. If the appropriate discount rate is
5%, how much is the lottery actually worth
today?

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Future Values for Annuities

• Suppose you begin saving for your retirement by
depositing $2000 per year in an trust. If the
interest rate is 8%, how much will you have in 40
years?

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Buying a House
• You are ready to buy a house and you have
$20,000 for a down payment and closing costs.
Closing costs are estimated to be 4% of the loan
value. You have an annual salary of $36,000
and the bank is willing to allow your monthly
mortgage payment to be equal to 28% of your
monthly income. The interest rate on the loan is
6% per year with monthly compounding (.5% per
month) for a 30-year fixed rate loan. How much
money will the bank loan you? How much can
you offer for the house?
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Buying a House - Continued

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Quick Quiz: Part 2

• 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 $5000 per month in
retirement. If you can earn .75% per
month and you expect to need the income
for 25 years, how much do you need to
have in your account at retirement?

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Finding the Payments

• Suppose you want to borrow $20,000 for a
new car. You can borrow at 8% per year
compounded monthly. If you take a 4 year
loan, what is your monthly payment?

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Finding the Number of Payments

• You have $1000 balance debt on your
credit card. You can only make a payment
of $20 per month. The interest rate is
1.5% per month. How long will you need
to pay off the $1000.

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Finding the Rate

– Financial Calculator
– Table
– Trial and error

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Finding the rates-Example
Suppose you borrow $10,000 from your parents to buy a
car. You agree to pay $2504.56 per year for 5 years.
What is the interest rate?

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Quick Quiz: Part 3

• Suppose you have $200,000 to deposit
and can earn 0.75% per month.
– How many months could you receive
the $5000 payment? (t=47.73mths)
– How much could you receive every
month for 5 years? (c=$4151.67)

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Annuity Due
• First payment occurs at the beginning of the
period
• Annuity due value=ordinary annuity value*(1+r)

 1 
1−
 t 
(1 + r )
PV =C (1 +r)
 r 
 
 
(1 +r) t −1
FV =C (1 +r)

 r 


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Annuity Due Timeline

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

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Perpetuity – Example
• Infinite series of equal payments
– Perpetuity formula: PV = C / r
• A preferred stock offers dividend of $2 per
year, What is the price of that stock is
going to sell if the required rate of return is
8%?

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Quick Quiz: Part 4

• 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?
• You are considering preferred stock that pays a
quarterly dividend of $1.50. If your desired return
is 12% per year, how much would you be willing
to pay?

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Tutorial
• Problem 6, 21, 26, 28, 30, 35, 47 and 49
from page 153

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