1

Principles of Finance
BS 2100

Present Values Expanded
Pete Hahn
Faculty of Finance
Room 5012
Cass Building
2
Topics Covered
Review Present Value

Foundations of the Net Present Value Rule
Valuing Long-Lived Assets
Looking for Shortcuts Perpetuities and Annuities
More Shortcuts Growing Perpetuities and
Annuities
Compound Interest & Present Values
3
Present and Future Value
Present Value
Value today of a
future cash
flow.
Future Value
Amount to which an
investment will grow
after earning interest
4
Discount Factors and Rates
Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Discount Factor
Present value of
a 1 future
payment.
5
Future Values
Future Value of $100 = FV


FV r
t
= + $100 ( ) 1
6
Future Values
FV r
t
= + $100 ( ) 1
Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?


82 . 133 $ ) 06 . 1 ( 100 $
5
= + = FV
7
Future Values
FV r
t
= + $100 ( ) 1
Example - FV
What is the future value of $400,000 if interest is
compounded annually at a rate of 5% for one year?

8
Present Value
1
factor discount = PV
PV = Value Present
C
9
Present Value
Discount Factor = DF = PV of $1




Discount Factors can be used to compute the present value of
any cash flow.
DF
r
t
=
+
1
1 ( )
10
Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C
0
= 370,000
Sale price in Year 1 = C
1
= 420,000

Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%

11
Valuing an Office Building
Step 3: Discount future cash flows



Step 4: Go ahead if PV of payoff exceeds
investment

000 , 400
) 05 . 1 (
000 , 420
) 1 (
1
= = =
+ +r
C
PV
000 30
000 370 000 400
,
, , NPV
=
=
12
Net Present Value
r
C
+
+
1
C = NPV
investment required - PV = NPV
1
0
13
Risk and Present Value
Higher risk projects require a higher rate
of return
Higher required rates of return cause
lower PVs
000 , 400
.05 1
420,000
PV
5% at $420,000 C of PV
1
=
+
=
=
14
Risk and Present Value
000 , 400
.05 1
420,000
PV
5% at $420,000 C of PV
1
=
+
=
=
15
Risk and Net Present Value
$5,000
370,000 - 75,000 3 = NPV
investment required - PV = NPV
=
16
Rate of Return Rule
Accept investments that offer rates of return
in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment
opportunity is 12%. Should we do the project?
13.5% or .135
370,000
370,000 420,000
investment
profit
Return =

= =
17
Net Present Value Rule
Accept investments that have positive
net present value
Example
Suppose we can invest $50 today and receive $60
in one year. Should we accept the project given a
10% expected return?


55 . 4 $
1.10
60
+ -50 = NPV =
18
Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on
the state of the economy, you may get one of
three possible cash payoffs:
140,000 110,000 $80,000 Payoff
Boom Normal Slump Economy
000 , 110 $
3
000 , 140 000 , 110 000 , 80
C payoff Expected
1
=
+ +
= =
19
Opportunity Cost of Capital
Example - continued
The stock is trading for $95.65. Next years
price, given a normal economy, is forecast at
$110

The stocks expected payoff leads to an
expected return.
15% or 15 .
65 . 95
65 . 95 110 profit expected
return Expected =

= =
investment
20
Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expected
return leads to the PV of the project



NPV requires the subtraction of the initial
investment
650 , 95 $
1.15
110,000
PV = =
350 , 4 $ 000 , 100 650 , 95 NPV = =
21
Opportunity Cost of Capital
Example - continued
Notice that you come to the same conclusion if
you compare the expected project return with
the cost of capital.
10% or 10 .
000 , 100
000 , 100 000 , 110 profit expected
return Expected =

= =
investment
22
Present Values





Discount Factors can be used to compute
the present value of any cash flow.
DF
r
t
=
+
1
1 ( )
1
1
1
1 r
C
C DF PV
+
= =
23
Present Values
Example
You just bought a new computer for 300. However, the
manufacturer allows you to pay for it in two years in
cash. If you can earn 8% on your money, how much
money should you set aside today in order to make the
payment when due in two years?
20 . 257
2
) 08 . 1 (
00 . 300
= = PV
24
Present Values
Example (for those of you from Baseball countries)
You have the opportunity to purchase the baseball hit by
Barry Bonds to break Hank Aarons home run record
(home run # 756). You estimate this baseball will be
worth $2,000,000 when you retire at the end of twenty
years. If you expect a 12% return on your investment,
how much will you pay for the baseball ?
334 , 207 $
20
) 12 . 1 (
000 , 000 , 2
= = PV
25
Present Values





Replacing 1 with t allows the formula
to be used for cash flows that exist at any
point in time
t
t
t
r
C
C DF PV
) 1 ( +
= =
26
Present Values
Example
You will receive $200 risk free in two years. If the annual
rate of interest on a two year Treasury note (considered a
risk free investment) is 7.7%, what is the present value of
the $200?



42 . 172 $
2
) 077 . 1 (
200
= = PV
27
Present Values
PVs can be added together to evaluate
multiple cash flows.
PV
C
r
C
r
= + +
+ +
1
1
2
2
1 1 ( ) ( )
....
28
Present Values
PVs can be added together to evaluate
multiple cash flows.
88 . 265
2 1
) 077 1 (
200
) 07 . 1 (
100
= + =
+ +
PV
29
Present Values
Present Value
Year 0

100/1.07
200/1.077
2
Total



= $93.46
= $172.42
= $265.88
$100
$200
Year
0 1 2
30
Present Values
Given two dollars, one received a year from now
and the other two years from now, the value of
each is commonly called the Discount Factor.
Assume r1 = 20% and r2 = 7%.
87 .
83 .
2
1
) 07 . 1 (
00 . 1
2
) 20 . 1 (
00 . 1
1
= =
= =
+
+
DF
DF
31
Present Values
Example
Assume that the cash flows
from the construction and sale
of an office building is as
follows. Given a 5% required
rate of return, create a present
value worksheet and show the
net present value.
000 , 320 000 , 100 000 , 170
2 Year 1 Year 0 Year
+
32
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
( )
011 , 25 $
249 , 290 000 , 320 907 . 2
238 , 95 000 , 100 952 . 1
000 , 170 000 , 170 0 . 1 0
Value
Present
Flow
Cash
Factor
Discount
Period
2
05 . 1
1
05 . 1
1
= =
+ + =
=

Total NPV
33
Present Values
Present Value
Year 0
-170,000
-100,000/1.05
320,000/1.05
2
Total = NPV
-$170,000


= -$170,000
= -$95,238
= $290,249
= $25,011
-$100,000
+$320,000
Year
0 1 2
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
34
Short Cuts
Sometimes there are shortcuts that make
it very easy to calculate the present value
of an asset that pays off in different
periods. These tools allow us to cut
through the calculations quickly.
35
Short Cuts
Perpetuity - Financial concept in which a
cash flow is theoretically received forever.
PV
C
r =
=
lue present va
flow cash
Return
36
Short Cuts
Perpetuity - Financial concept in which a
cash flow is theoretically received forever.
r
C
PV
1
0
rate discount
flow cash
Flow Cash of PV
=
=
37
Present Values
Example
What is the present value of $1 billion every year, for all
eternity, if you estimate the perpetual discount rate to be
10%??



billion 10 $
10 . 0
bil $1
= = PV
38
Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.
r
C
Perpetuity (first
payment in year 1)
Perpetuity (first payment
in year t + 1)
Annuity from year
1 to year t
Asset Year of Payment
1 2..t t + 1
Present Value
t
r r
C
) 1 (
1
+
|
.
|

\
|
|
|
.
|

\
|
+
|
.
|

\
|

|
.
|

\
|
t
r r
C
r
C
) 1 (
1
39
Example
For my new super-green car, Ajax Autos offers me easy payments of
5,000 per year, at the end of each year for 5 years. If interest rates are
7%, per year, what is the cost of the car? I can buy it now for 23,000.
Present Values
5,000
Year
0 1 2 3 4 5
5,000 5,000 5,000 5,000
( )
( )
( )
( )
20,501 NPV Total
565 , 3 07 . 1 / 000 , 5
814 , 3 07 . 1 / 000 , 5
081 , 4 07 . 1 / 000 , 5
367 , 4 07 . 1 / 000 , 5
673 , 4 07 . 1 / 000 , 5
5
4
3
2
=
=
=
=
=
=
Present Value at
year 0
What should I do?
40
Short Cuts
Annuity - An asset that pays a fixed sum
each year for a specified number of years.
( )
(

+
=
t
r r
r
C
1
1 1
annuity of PV
41
Annuity Short Cut
Example
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?
42
Annuity Short Cut
Example - continued
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?
( )
10 . 774 , 12 $
005 . 1 005 .
1
005 .
1
300 Cost Lease
48
=
(

+
=
Cost
43
Real Life
Example
A 62 year-old brokerage client came in to see his broker. The client
won the (US) Illinois State Lottery with a prize of $60mm, payable
over 30 years at $2mm p.a. We were asked to find a buyer for the
ticket. We held an auction by rate. Illinois 15-year bonds were
trading at 6.0% and the winner bid 6.2%.
Lottery Value $2mm
1
.062

1
.062 1+.062
( )
30

Value $26, 950, 408 (BankFees)

44
FV Annuity Short Cut
Future Value of an Annuity The future value of
an asset that pays a fixed sum each year for a
specified number of years.
( )
(

+
=
r
r
C
t
1 1
annuity of FV
45
Annuity Short Cut
Example
What is the future value of $20,000 paid at the end of each
of the following 5 years, assuming your investment returns
8% per year?
( )
332 , 117 $
08 .
1 08 . 1
000 , 20 FV
5
=
(

+
=
46
Constant Growth Perpetuity
g r
C
PV

=
1
0
g = the annual growth rate of
the cash flow
47
Constant Growth Perpetuity
g r
C
PV

=
1
0
NOTE: This formula can be used
to value a perpetuity at any point
in time.
g r
C
PV
t
t

=
+1
48
Constant Growth Perpetuity
Example
What is the present value of $1 billion paid at the end of
every year in perpetuity, assuming a rate of return of 10%
and a constant growth rate of 4%?
49
Perpetuities
A three-year stream of cash flows that grows at the rate g
is equal to the difference between two growing
perpetuities.
50
Compound Interest
i ii iii iv v
Periods Interest Value Annually
per per APR after compounded
year period (i x ii) one year interest rate

1 6% 6% 1.06 6.000%

2 3 6 1.03
2
= 1.0609 6.090

4 1.5 6 1.015
4
= 1.06136 6.136

12 .5 6 1.005
12
= 1.06168 6.168

52 .1154 6 1.001154
52
= 1.06180 6.180

365 .0164 6 1.000164
365
= 1.06183 6.183
51
Simple and Compound Interest
The value of a $100 investment earning 10% annually.
52
Compound Interest
Compound interest versus simple interest. The top two ascending lines
show the growth of $100 invested at simple and compound interest. The
longer the funds are invested, the greater the advantage with compound
interest. The bottom line shows that $38.55 must be invested now to
obtain $100 after 10 periods. Conversely, the present value of $100 to be
received after 10 years is $38.55.
0
200
400
600
800
1000
1200
1400
1600
1800
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
F
V

o
f

$
1
0
0
0%
5%
10%
15%
Compound Interest
Interest Rates
0
20
40
60
80
100
120
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
P
V

o
f

$
1
0
0
0%
5%
10%
15%
Present Values with Compounding
Interest Rates
55
Compound Interest
Example
Suppose you are offered an automobile loan at an APR of
6% per year. What does that mean, and what is the true
rate of interest, given monthly payments?
56
Compound Interest
Example - continued
Suppose you are offered an
automobile loan at an APR of 6% per
year. What does that mean, and what
is the true rate of interest, given
monthly payments? Assume $10,000
loan amount.

% 1678 . 6
78 . 616 , 10
) 005 . 1 ( 000 , 10 Pmt Loan
12
=
=
=
APR
57
See you next week