MODULE 2

(Wiley Resource - Chapter 6

Customized & Abridged)
Dr. Tasadduq Imam

Chapter 6
Discounted cash flows
and valuation
Prepared by
Alex Proimos & Chee Jin Yap

Basics

Multiple cash flows

Future value of multiple cash flows
Solving future value problems with multiple cash flows:
1. Draw timeline to ascertain each cash flow is placed
in correct time period
2. Calculate future value of each cash flow for its time
period
3. Add up the future values

Future value of three cash flows

Multiple cash flows

Present value of multiple cash flows
Many business situations call for computing present
value of a series of expected future cash flows
determining market value of

security
deciding whether to make capital
investment

Process similar to determining

future value of multiple cash

flows

Multiple cash flows

Present value of multiple cash flows
First, prepare timeline to identify magnitude and timing

of cash flows
Next, calculate present value of each cash flow
Finally, add up all present values.
Sum of present values of stream of future cash flows is
their current market price, or value

Present value of three cash flows

A Math

Kronya Ltd is expecting cash flows of $13 000, $11 500,

$12 750, and $9635 over the next 4 years. What is the
present value of these cash flows if the appropriate
discount rate is 8 per cent?
Solution:

Another Math

Your grandfather has agreed to deposit a certain

amount of money each year into an account paying
7.25 per cent annually to help you go to university.
Starting next year, and for the following 4 years, he
plans to deposit $2250, $8150, $7675, $6125, and
$12 345 into the account. How much will you have at
the end of the 5 years?
Solution:

Annuity, Perpetuity

Level cash flows: annuities and

perpetuities
Present value of an annuity
Many situations exist where businesses and individuals

would face either receiving or paying constant amount

for length of period
Annuity stream of cash flows when company faces stream of

constant payments on a bank loan for a period of time

Individual investors may make constant payments on home or
car loans, or invest fixed amount year after year saving for
retirement

Level cash flows: annuities and

perpetuities
Annuities and perpetuities
Annuity: any financial contract calling for equally spaced
level cash flows over finite number of periods
Ordinary annuity: constant cash flows occurring at end of each

period
Annuity due: constant cash flows occurring at beginning of
each period

Perpetuity: contract calling for cash flow payments to

continue forever

Annuity

Present Value of Ordinary Annuity

1

(1 i / m)m x n
PVAn (CF / m)
i/m

CF is the series of equal cash flows per year

i is the rate of interest per annum
m is the number of compounding per year
n is the number of years

A Math on PV of an Ordinary Annuity

Dynamo Ltd is expecting annual payments of $34225

for the next 7 years from a customer. What is the
present value of this annuity if the discount rate is 8.5
per cent?
Solution:

m=1

A Math on PV of an Ordinary Annuity

Dynamo Ltd is expecting annual payments of $34225

for the next 7 years from a customer. What is the
present value of this annuity if the discount rate is 8.5
per cent?
Solution (Same Math: without using Formula)
$34225
= $31543.78
(1 + .085)1
$34225
= $29072.61
PV of the 2nd cash flow =
(1 + .085)2
$34225
rd
= $26795.03
PV of the 3 cash flow =
(1 + .085)3
$34225
= $24695.88
PV of the 4th cash flow =
(1 + .085)4
PV of the 1st cash flow =

$34225
= $22761.18
(1 + .085)5
$34225
= $20798.05
PV of the 6th cash flow =
(1 + .085)6
$34225
th
= $19334.60
PV of the 7 cash flow =
(1 + .085)7
PV of the 5th cash flow =

Total PV = $175181.13
Same result using
Formula Yet, formula
Is better particularly
since (m X n) can be
large

Extra Math Involving Ordinary Annuity

You have borrowed $10,000, repayable by equal halfyearly instalments for five years. If interest is 5% p.a.
compounded half-yearly, what will be your half-yearly
repayments?
Solution:
1

(1 i / m)m x n
PVAn (CF / m)

i
/
m

PVAn $10,000; CF ?; m 2; i 5% 0.05; n 5

1

2
x
5
(1 0.05 / 2)

10,000 (CF / 2)

0.05 / 2

10,000 CF x 4.376032
CF=$2285.18

This CF=$2285.18 is annual.

So, half-yearly repayment is
CF/2 = $2285.18/2 = $1142.59

Annuity

Future Value of Ordinary Annuity

(1 i / m)m x n 1
FVAn (CF / m)

(i
/
m)

CF is the series of equal cash flows per year

i is the rate of interest per annum
m is the number of compounding per year
n is the number of years

A Math on FV of an Ordinary Annuity

Mike White is planning to save up for a trip to Europe in 3 years.
He will need $10000 when he is ready to make the trip. He plans
to invest the same amount at the end of each of the next 3 years
in an account paying 6 per cent. What is the amount he will
have to save every year to reach his goal of $10000 in 3 years?

Solution:

On Next Slide

A Math on FV of an Ordinary Annuity

m=1

Annuity Due
Annuities due
Annuity is called an annuity due when there is an
annuity with payment being incurred at beginning of
each period rather than at end
Rent or lease payments typically made at beginning of
each period rather than at end

Ordinary annuity vs annuity due

Annuity Due
Annuities due
Annuity transformation method shows relationship
between ordinary annuity and annuity due
Each periods cash flow thus earns extra period of
interest compared to ordinary annuity
present or future value of annuity due is always higher than

that of ordinary annuity

Annuity due = Ordinary annuity value (1+i)

Annuity

Present Value of Annuity Due

PVADue PVAOrd

CF
1
1 i
1
1 i
n
i
1 i

CF is the series of equal cash flows per year

i is the rate of interest per annum
n is the number of years
assuming annual compounding in this formula

e.g., Ordinary annuity

versus annuity due
An investment opportunity requires a payment of $750 for 12 years, starting a
year from today. If your required rate of return is 8 per cent, what is the value
of the investment today? Now, assume this is an annuity due with payments
starting today. Recalculate the PV of this investment.

CF
1
PVAOrd
1
$5, 652.06
n
i
1 i

750
1
PVADue PVAOrd 1 i
1
1.08
12
0.08
(1.08)

PVADue 750 7.5361 1.08 5,652.06 1.08

PVADue $6,104.22

Slide 25

e.g. PV of an ordinary
annuity
Present value of an ordinary annuity: An investment
opportunity requires a payment of $750 for 12 years,
starting a year from today. If your required rate of return is
8 per cent, what is the value of the investment today?

CF
1
PVAn
1
n
i
1 i

750
1

1
750 7.5361
12
0.08
(1.08)
$5, 652.06
Slide 26

e.g. Ordinary annuity

versus annuity due
Recall Q from Previous slide : An investment opportunity requires
a payment of $750 for 12 years, starting a year from today. If your required
rate of return is 8 per cent, what is the value of the investment today? Now,

assume this is an annuity due with payments starting today.

Recalculate the PV of this investment.

PVAOrd
PVADue
PVADue

CF
1

1
$5, 652.06
n
i
1 i

750
1
PVAOrd 1 i
1
1.08
12
0.08
(1.08)
750 7.5361 1.08 5, 652.06 1.08

PVADue $6,104.22
Slide 27

Perpetuities
A perpetuity is constant stream of cash flows that goes
on for infinite period
In share markets, preference shares issues are
considered to be perpetuities, with issuer paying a
constant dividend to holders
Equation for present value of a perpetuity can be
derived from present value of an annuity equation with
n tending to infinity:

Perpetuities
PVA CF Present value factor for annuity
1

1 (1 i )
(1 0 )
CF
CF
i
i

CF
i

A Math on Perpetuity
Becky Scholes has $150 000 to invest. She wants to be able to
withdraw $12500 every year forever without using up any of her
principal. What interest rate would her investment have to earn in
order for her to be able to so?

Solution:

Another Math on Perpetuity

Calculate the perpetuity payments for the following

case:
$250000 invested at 6 per cent.
Solution:
Annual payment = CF
Investment rate of return = i = 6%
Term of payment = Perpetuity
Present value of investment needed = PVA = $250000
PV of Perpetuity, PVA = CF/i
So, CF = PVA x i = $250000 x .06 = $15,000

Cash flows that grow at a

constant rate
In addition to constant cash flow streams, one may have
to deal with cash flows that grow at constant rate over
time
These cash-flow streams called growing annuities or
growing perpetuities

Cash flows that grow at a

constant rate
Growing annuity
Business may need to calculate value of multiyear
product or service contracts with cash flows that
increase each year at constant rate
These are called growing annuities.

Example of growing annuity: valuation of growing

business whose cash flows increase every year at

constant rate

Cash flows that grow at a

constant rate
Growing annuity
Use this equation to value the present value of growing
annuity when the growth rate is less than discount rate

Cash flows that grow at a

constant rate
Growing perpetuity
When cash flow stream features constant growing
annuity forever

CF1
PVA =
(i - g)

e.g. Growing annuity

Growing annuity: Gull Petroleum Ltd owns several service stations. Management is
looking to open a new station in the northern suburbs of Perth. One possibility they
are evaluating is to take over a station located at a site that has been leased from the
state government. The lease, originally for 99 years, currently has 73 years before
expiration. The service station generated a net cash flow of $92,500 last year, and
the current owners expect an annual growth rate of 6.3 per cent. If Gull uses a
discount rate of 14.5 per cent to evaluate such businesses, what is the present value
of this growing annuity?

PVAGrowing

n
73

CF1
92, 500 1.063
1 g
1.063

1
1


(i g ) 1 i (0.145 0.063) 1.145
98, 327.50

1 0.92838427973
0.082
1199115.854 0.995593154 $1,193, 831.54
Slide 36

e.g. Growing perpetuity

Growing perpetuity: You are evaluating a growing perpetuity
product from a large financial services company. The product
promises an initial payment of $20,000 at the end of this year and
subsequent payments that will thereafter grow at a rate of 3.4 per
cent annually. If you use a 9 per cent discount rate for investment
products, what is the present value of this growing perpetuity?

CF1
20, 000
PVA

(i g ) (0.09 0.034)
$357, 142.86
Slide 37

Term Loans

Level cash flows: annuities and

perpetuities
Preparing a loan amortisation schedule
Amortisation: the way the borrowed amount (principal)

is paid down over life of loan

Monthly loan payment is structured so each month
portion of principal is paid off; at time loan matures, it is
entirely paid off

Level cash flows: annuities and

perpetuities
Preparing a loan amortisation schedule
Amortised loan: each loan payment contains some
payment of principal and an interest payment
Loan amortisation schedule is a table showing:

loan balance at beginning and end of each period

payment made during that period
how much of payment represents interest
how much represents repayment of principal

Level cash flows: annuities and

perpetuities
Preparing a loan amortisation schedule
With amortised loan, larger proportion of each months
payment goes towards interest in early periods
as loan is paid down, greater proportion of each payment is

used to pay down principal

Amortisation schedules are best done on a spreadsheet

NOTE THE MATH ON LOAN

AMORTIZATION ON PAGE 194
(FIG. 6.5)

The effective annual interest rate

Interest rates can be quoted in financial markets in
variety of ways
Most common quote, especially for a loan, is annual

percentage rate (APR)

APR represents simple interest accrued on loan or

investment in a single period; annualised over a year by

multiplying it by appropriate number of periods in a year

The effective annual interest rate

Calculating the effective annual rate (EAR)
Correct way to calculate annualised rate is to reflect
compounding that occurs; involves calculating effective
annual rate (EAR)
Effective annual interest rate (EAR) defined as annual
growth rate that takes compounding into account

The effective annual interest rate

Calculating the effective annual rate (EAR)
EAR = (1 + Quoted rate/m)m 1
- m is the # of compounding periods during a year
EAR conversion formula accounts for number of
compounding periods, thus effectively adjusts
annualised interest rate for time value of money
EAR is the true cost borrowing and lending.

e.g. EARs
Effective annual rate: Cyclone Rentals borrowed $15,550 from a
bank for 3 years. If the quoted rate (APR) is 6.75 per cent, and the
compounding is daily, what is the effective annual rate (EAR)?
m

i
0.0675

EAR 1 1 1
m
365

1.0698 1 6.98%

365

Slide 46

Few More Maths on

Annuity

Calculating annuity
PMT
Brian is a Year 9 student. He plans to buy a car in 4 years.
He estimates that the car will cost him $22,000 in 4 years.
How much money should Brian save each year if he wants
to buy the car? Assume his savings account earns 5.65
per cent annually.
m 1
(1 i )n 1
FVAn CF

22,000 CF 4.351949362

1.05654 1
22,000 CF

0.0565

22,000
CF
$5,055.21
4.351949362
Slide 48

e.g. Calculating annuity

n

Christine wants to accumulate $247,609.95 so that she can purchase an apartment.

She plans to invest $25,000 at the end of each year. If Christine's savings earn
11.4% p.a., how long will it take for her to reach her goal?

m 1

(1 i )n 1
FVAn CF

1.114n 1
247,609.95 25,000

0.114

247,609.95 1.114n 1

25,000
0.114

1.114n 1
9.904398
0.114

9.904398 0.114 1.114n 1

1.129101372 1 1.114n

2.129101372 1.114n

log 2.129101372 n log1.114

0.328196339
n 7 years
Slide 49
0.04688519

0.328196339 n 0.04688519


WORKSHOP & OTHER
ACTIVITIES

Workshop Questions &

Problems

Chapter 6 - Parrino et. al. 2014

Critical Thinking Questions
6.3, 6.4, 6.8, 6.9

Numerical Problems:
6.1, 6.2, 6.4, 6.5, 6.7, 6.9, 6.11, 6.12, 6.13, 6.14,
6.15, 6.16, 6.18, 6.19, 6.21, 6.22, 6.23, 6.25, 6.27,
6.29, 6.31, 6.35