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=
+
n
t
r
1
t
t
) 1 (
A
where, PV
n
= present value of cash flow stream
A
t
= cash flow occuring at the end of year t
r = discount rate
n = duration of the cash flow.
Calculating the Present Value of an Investment Opportunity
Suppose you own a small company that is contemplating
construction of an office block. The total cost of buying the
land and constructing the building is Rs. 3,70,000, but your
real estate adviser forecasts a shortage of office space a
year from now and predicts that you will be able to sell the
building for Rs. 4,20,000.
For simplicity, we will assume that this Rs. 4,20,000 is a
sure thing.
You should go ahead with the project if the present value of
future cash inflows is higher than Rs. 3,70,000.
Q. Is this investment really a sure thing?
How to Value Perpetuities
Consols are perpetuities issued by British Government.
These are bonds that the Government is under no obligation to
repay but that offer a fixed income for each year to perpetuity.
The British government still paying interest on Consols issued
all those years ago.
The annual return on a perpetuity is equal to the promised
annual payment divided by the present value:
Return = Cash inflow/Present Value
Or Present Value = Cash inflow/return
III. Future Value Of An Annuity :
An annuity is a stream of cash flow (payment or receipt) occurring
at regular interval of time.
When cash flows occur at the end of each period the annuity is
called an ordinary annuity or a deferred annuity.
When cash flow occur at the beginning each period, the annuity
is called an annuity due.
The formula for calculating the future value of an annuity is
FVA
n
= A [(1+r)
n
1] / r
where FVA
n
= future value of an annuity for duration of n years
A = constant periodic flow
r = interest rate per period
n = duration of the annuity
The term [(1+r)
n
1] / r is referred to as the future value interest
factor for an annuity (FVIFA
r,n
).
Applications :
The future annuity formula can be applied in different cases.
IV. Present Value Of An Annuity :
In this case we calculate the present value of stream of cash
inflows.
The present value of an annuity is actually the sum of the present
value of all the inflows of this annuity.
The formula for calculating the present value of an annuity is
PVA
n
=
n 2
r) (1
A
...
r) (1
A
r) (1
A
+
+ +
+
+
+
PVA
n
= A {[(1+r)
n
1] / r (1+r)
n
}
where PVA
n
= present value of an annuity for n years
A = constant periodic flow
r = discount rate
The factor - [(1+r)
n
1] / r (1+r)
n
is referred as present value
interest factor for an annuity (PVIFA
r,n
).
Present Value of a Growing Annuity :
A cash flow that grows at a rate for a specified period of time is
a growing annuity.
The formula for present value of a growing annuity is
PVGA = A (1+g)
(
(
(
(
+
+
g - r
r) (1
) g 1 (
1
n
n
The above formula can be used when the growth rate is either
less than or more than discount rate (g<r or g>r).
However it does not work when growth rate and discount rate are
equal. In this case, the present value is simply equal to n A.
Annuities Due :
When cash flow occur at the beginning of each period, such an
annuity is called as annuity due.
Since the cash flows of an annuity due occur one period earlier
in comparison to the cash flows of an ordinary annuity, the
formula for annuity due will be
Annuity due value = Ordinary annuity value (1+r)
Present Value of a Perpetuity :
A perpetuity is an annuity of infinite duration. It may be expressed
as
P
= A PVIFA
r,
where P
=
o
t
Thus it means that the present value interest factor of a perpetuity
is simply 1 divided by the interest rate expressed in decimal form.
Intra-Year Compounding And Discounting :
Here we will discuss the case where compounding / discounting
is done more frequently, i.e., more than once a year (like
semi-annually, quarterly, monthly etc)
The general formula for the future value of a single cash flow
after n years when compounding is done m times a year
FV
n
= PV
n m
(
+
m
r
1
If compounding is done more than once a year, effective interest
rate will be different than stated interest rate.
The general relationship between the effective interest rate and
the stated annual interest rate is as follows
Effective interest rate =
1
m
rate interest annual Stated
1
(
+
m
where m is the frequency of compounding per year.
Sometimes cash flows have to be discounted more frequently than
once a year.
The general formula for calculating the present value in the case of
shorter discounting period is
PV = FV
n
n m
(
(
+
m
r
1
1
where PV = present value
FVn = cash flow after n years
m = number of times per year discounting is done
r=annual discount rate
When compounding becomes continuous, the effective interest is
expressed as
e
r
1,
where e = base of natural logarithm and r = stated interest rate.