Chapter 2

Principles of
Corporate Finance
Tenth Edition

How to Calculate
Present Values

Slides by
Matthew Will

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Topics Covered
Future Values and Present Values
Looking for ShortcutsPerpetuities and
Annuities
More ShortcutsGrowing Perpetuities and
Annuities
How Interest Is Paid and Quoted

2-2

Present and Future Value

Future Value
Amount to which an
investment will grow
after earning interest
Present Value
Value today of a
future cash
flow.

2-3

2-4

Future Values
Future Value of $100 = FV

FV $100 (1 r )

Future Values
FV $100 (1 r )

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 7% for two years?
FV $100 (1.07) (1.07) 114 .49
FV $100 (1 .07) 2 $114 .49

2-5

Future Values with Compounding

Interest Rates

2-6

Present Value

Present Value = PV
PV = discount factor C1

2-7

Present Value
Discount Factor = DF = PV of $1

DF

1
(1 r ) t

Discount Factors can be used to compute the present value of

any cash flow.

2-8

Present Value
The PV formula has many applications. Given
any variables in the equation, you can solve for the
remaining variable. Also, you can reverse the prior
example.

PV DF2 C2
PV

1
(1.07 ) 2

114 .49 100

2-9

Present Values with Compounding

Interest Rates

2-10

Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 370,000
Sale price in Year 1 = C1 = 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%

2-11

Valuing an Office Building

Step 3: Discount future cash flows

PV

C1
(1r )

420 , 000
(1 .05 )

400,000

Step 4: Go ahead if PV of payoff exceeds investment

NPV 400 ,000 370 ,000

30 ,000

2-12

Net Present Value

NPV = PV - required investment
C1
NPV = C0
1 r

2-13

Risk and Present Value

Higher risk projects require a higher rate of
return
Higher required rates of return cause lower
PVs

PV of C1 $420,000 at 5%
420,000
PV
400,000
1 .05

2-14

Risk and Present Value

2-15

PV of C1 $420,000 at 12%
420,000
PV
375,000
1 .12

PV of C1 $420,000 at 5%
420,000
PV
400,000
1 .05

Risk and Net Present Value

NPV = PV - required investment
NPV = 375,000 - 370,000
$5,000

2-16

Net Present Value Rule

Accept investments that have positive net
present value
Example
Use the original example. Should we accept the
project given a 10% expected return?

420,000
NPV = -370,000 +
$30,000
1.05

2-17

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?
profit
420,000 370,000
Return

.135 or 13.5%
investment
370,000

2-18

2-19

Multiple Cash Flows

For multiple periods we have the
Discounted Cash Flow (DCF) formula

PV0

C1

Ct

C2

(1 r )

(1 r ) 2 .... (1 r )t
T

NPV0 C0 (1 r )t
t 1

Ct

2-20

Net Present Values

- $370,000
$20,000

$ 420,000

Present Value
Year 0

-$370,000
20,000/1.12 = $17,900
420,000/1.122 = $334,800
Total = - $17,300

Year

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.

2-21

Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.

cash flow
Return
present value
C
r
PV

2-22

Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.

cash flow
PV of Cash Flow
discount rate
C1
PV0
r

2-23

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%??

PV

$1 bil
0.10

$10 billion

2-24

Present Values
Example - continued
What if the investment does not start making money for 3
years?

PV

$1 bil
0.10

$7.51 billion
1
1.103

2-25

2-26

Short Cuts

Annuity - An asset that pays a fixed sum each year for a

specified number of years.
Asset

Year of Payment
1

Perpetuity (first
payment in year 1)

2..t

t+1

Present Value

C
r

Perpetuity (first payment

in year t + 1)

1
C

t
r (1 r )

Annuity from year

1 to year t

1
C C

t
r r (1 r )

2-27

Present Values
Example

Tiburon Autos offers you 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?
5,000
Present Value
at year 0

5,000

5,000

5,000
Year

5,000 / 1.07 4,673

5,000 / 1.07 4,367
2

5,000 / 1.07 4,081

3

5,000 / 1.07 3,814

4

5,000 / 1.07 3,565

Total NPV 20,501
5

5,000

Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.

1
1
PV of annuity C
t
r r 1 r

2-28

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?

2-29

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?

1
1
Lease Cost 300

48
.005 .0051 .005
Cost $12,774.10

2-30

Annuity Short Cut

Example
The state lottery advertises a jackpot prize of $295.7
million, paid in 25 installments over 25 years of $11.828
million per year, at the end of each year. If interest rates
are 5.9% what is the true value of the lottery prize?

1
1
Lottery Value 11.828

25
.
059
.0591 .059

Value $152,600,000

2-31

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.

1 r t 1
FV of annuity C

2-32

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?

1 .08 5 1
FV 20,000

.08

$117 ,332

2-33

Constant Growth Perpetuity

C1
PV0
rg

g = the annual growth

rate of the cash flow

2-34

Constant Growth Perpetuity

NOTE: This formula can be
used to value a perpetuity at
any point in time.

C1
PV0
rg

C t 1
PVt
rg

2-35

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%?

1
PV0
.10 .04
$16.667 billion

2-36

Perpetuities
A three-year stream of cash flows that grows at
the rate g is equal to the difference between
two growing perpetuities.

2-37

Effective Interest Rates

Effective Annual Interest Rate - Interest rate
that is annualized using compound interest.

Annual Percentage Rate - Interest rate that is

annualized using simple interest.

2-38

Effective Interest Rates

example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?

2-39

Effective Interest Rates

example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?
12

EAR = (1 + .01) - 1 = r
EAR = (1 + .01)12 - 1 = .1268 or 12.68%
APR = .01 x 12 = .12 or 12.00%

2-40

Web Resources
Click to access web sites
Internet connection required
www.smartmoney.com
http://finance.yahoo.com
www.in.gov/ifa/files/TollRoadFinancialAnalysis.pdf
www.mhhe.com/bma

2-41