Present Value Basics I

By; Fitri Santi

Fitri Santi, SE, M.Si

 Future Value of a Cash Flow

• Suppose the compound interest rate in the market is 10% per

annum.
• This means that the future value of $1 one year from now will
be $1.10, and two years from now will be $1.21.
• In general, if the discount rate is i, then the future value of
PMT dollars one period from today is PMT(1+i), two periods
from today is PMT(1+i)2, and n periods from today is PMT(1+i)n.
• We refer to today's value PMT as PV (for present value) and to
the future value PMT(1+i)n as FVn (for future value at time n).

<Fitri Santi, SE, M.Si>

Example 1
• Suppose the compound interest rate is 12% per annum.
The future value after one year of $150 is given by :
• FV1 = 150(1+0.12) = $168.
• After two years FV2 = 150(1+0.12)2 = $188.16.
• After n years FVn = 150(1.12)n.
Example 2
• Suppose i = 8% and PV = $8000. What is the future
value of the amount after seven years? After twenty
years?
• Solution
• FV7 = 8000(1+0.08)7 = $13,712
• FV20 = 8000(1+0.08)20 = $37,287.66

<Fitri Santi, SE, M.Si>

 Present Value of a Cash Flow
• Now let us consider the converse of a future value. Suppose
the compound interest rate in the market is 10% per annum.
In addition, you are told that one year from now you will
have $1.10.
• What is the present value of this amount? Of course, $1.
This is because $1 today is $1.10 after one year if the
discount rate is 10%.
• What if you are told that one year from now you will have
$1? The present value of $1 obtained one year from now is
$0.91.
• In general, if the discount rate is i, then the present value
of PMT dollars obtained one period from today is PMT/(1+i),
obtained two periods from today is PMT/(1+i)2, and obtained
n periods from today is PMT/(1+i)n.

<Fitri Santi, SE, M.Si>

Example 1
• Suppose the compound interest rate is 10% per annum.
The present value of $100 obtained one year from today
is given by:
• PV = 100/(1+0.1) = $90.91.
• Of $100 obtained two years from today PV = 100/(1+0.1)2
= $82.64.
• Of $100 obtained n years from today PV = 100/(1.1)n.
Example 2
• Suppose $500 grows to $1039.50 at a rate of 5%. How
many years was the amount invested?
• Solution
We have 1039.50 = 500(1+0.05)n and we need to solve for n.
FVn = (1.05)n = 2.079
• The easy way: look up future value tables for i = 5%, and
find the year when future value of a dollar becomes
2.079.We get n = 15 years

<Fitri Santi, SE, M.Si>

One More Example
• Peter Minuet, the first director general of New Netherlands
province, purchased Manhattan Island from the local Canarsee
Indians for approximately $24 in 1626. It is often claimed that
the Indians got a raw deal. If the appropriate discount rate is
8%, what would the $24 the Indians collected be worth in
1990?
Solution
• Note that FV364 = 24(1.08)364 = $35,193,157,973,930 = $35
trillion plus!
• What would be the worth of the $24 if the appropriate
discount rate was 10%?
Another Example
• A zero-coupon bond is a bond that pays no coupon and sells at a
discount. Suppose a zero-coupon bond promises to pay $1000
after 28 years. The appropriate discount rate for the bond
(given its risk characteristics) is 9.5%. What is the bond’s
current market price?
• Further, if you believe that the proper discount rate for the
bond is 9.2%, would you buy or sell it at the market price of
$78.78?

<Fitri Santi, SE, M.Si>

Solution
• The market price of the bond is the discounted value of
$1000, i.e., market price = PV = 1000/(1+0.095)28 = $78.78.
By your reckoning the proper discount rate is 9.2% and so PV
= 1000/(1+0.092)28 = $85.07.
• This means that the bonds are undervalued at the market
price of $78.78. So you will buy the bonds at $78.78.
• The intriguing question is when will you quit buying? One
possibility is that your buying spree is unable to make much
of a dent in the price of the bond: you could run out of cash
or money, i.e., you are no longer able to put your money where
your mouth is, so to say; or you could change your mind
before you run out of money, learning by the immobility of
the price and seeing as well the investor support behind the
price.
• On the other hand you could start a movement and, joined by
others, convince the market of its initial error, taking the
price to a new equilibrium value where you stand satiated, no
longer wishing to trade, having done your part in driving
markets. Care to take a hot at supplying the numbers behind
these vagaries?

<Fitri Santi, SE, M.Si>

 Present Value of Two or More Cash Flows

What happens when you have two or more cash flows? Can we
write their present value? Let us look at the following example:
Example
Suppose i = 10% and we have:

Then present value (PV) of the cash flows is the sum

of the present values of the three flows, i.e.,
90.91+185.95+105.18 = $382.04.

<Fitri Santi, SE, M.Si>

 Present Value of a Set of Cash Flows
Consider a set of cash flows {PMT}, starting at time 1
and going up to time n, and a discount rate i.

Then the present value of the cash

flows {PMT } is given by the following
equation:

The net present value (NPV) includes the initial investment PMT0.
The net present value of the cash flows is given by the following
equation:

<Fitri Santi, SE, M.Si>

The following notation is standard:

The Net Present Value Rule

Accept a project if its NPV is positive

<Fitri Santi, SE, M.Si>

Example
Suppose a project requires an initial investment of
$60,000. At the end of the first year you expect to lose
$20,000. At the end of the second year (which is also the
end of the project) you expect to gain $100,000. You assess
that, given the risk of the project, a cost of capital of 12%
is appropriate. Should you accept the project?
Solution

You should do the project because it has an NPV that is

greater than zero which means that the project adds value

<Fitri Santi, SE, M.Si>

 Present Value of a Perpetuity
A perpetuity is a constant payment of PMT every period forever.
By assumption, the payment PMT occurs at the end of each period.
The first payment occurs at time 1, the second at time 2, and so on.

The present value of a perpetuity is worked out as follows:

Multiplying through by (1+i) we get:

Subtracting the first equation

from the second and dividing through
by i we get:
<Fitri Santi, SE, M.Si>
Example
• In the 1800s, the British Government
decided to consolidate all its debt
through a single issue of 2.5% consols. A
2.5% consol was a perpetuity promising to
pay £25 each year forever. Suppose the
appropriate discount rate for a consol is
8.5%. What is the price of a consol?
Solution
• Price = PMT/i = 25/0.085 = £294.12

<Fitri Santi, SE, M.Si>

Present Value of a Growth Perpetuity

• A growth perpetuity is a payment that starts with

PMT and grows every period at a growth rate g
forever. By assumption, the payment occurs at the
end of each period. The first payment occurs at
time 1, the second at time 2, and so on. In general,
a payment of PMT(1+g)n-1 occurs at time n.

<Fitri Santi, SE, M.Si>

The present value of a growth perpetuity is
worked out as follows:

Multiplying through by (1+i)/(1+g) we get:

Subtracting the first equation from the second and

simplifying we get:

<Fitri Santi, SE, M.Si>

Example
Benefactor proposes to endow a chair at the Business School
of the University of Iowa. The proposal is to provide
$150,000 plus a raise of 5% each year. Suppose the interest
rate earned by endowments is 10%. How much should the
benefactor donate?
Solution

A Lively Example
As a cemetery manager, you are considering offering
perpetual care contracts. You estimate that maintenance will
cost you $250 during the first year and will increase by 2.8%
every year thereafter. If the appropriate discount rate is
7.5%, how much do you need to charge to break even on a
perpetual care contract?
Solution: $250/(.075-.028) = $5,319.15.

<Fitri Santi, SE, M.Si>

 Present Value of an
Annuity
• An annuity is like a perpetuity except that it does
not go on forever: It is a constant payment PMT
every period until time n.
• By assumption, the payment PMT occurs at the
end of each period.
• The first payment occurs at time 1, the second at
time 2, and so on.
• The present value of an annuity is easiest to work
out by thinking of it as a difference between two
perpetuities:

<Fitri Santi, SE, M.Si>

<Fitri Santi, SE, M.Si>
Example
Consider a 30-year mortgage with annual payments of
$15,000. If the interest rate is 10%, what is the value of
the mortgage?
Solution

= $141,403.70

Another Example
As a cemetery manager, you are considering offering 50-year
care contracts. You estimate that maintenance will average
$325 each year.
If the appropriate discount rate is 7.5%, how much do you need
to charge to break even on such a contract?
Solution

You should charge the present value of your costs

to break even, i.e., $4,216.81.
<Fitri Santi, SE, M.Si>
A Retirement Example
Suppose I retire in 40 years. I wish to plan for the first 30 years of
my retirement. In particular, I would like to have saved enough
money by that time that I can consume $30,000 each year for the
first 30 years of retirement. If the annual interest rate I earn on
my retirement savings is 8%, how much do I need to save over the
next 40 years?
Solution We start by asking how much do I need in my retirement
account when I retire? The answer:

Now, suppose we ask how much do I need to save each year for the
next 40 years so I can have $337,733.50 in my account when I
retire. The answer, this time, comes from the future value
expression. You save a fixed amount to end up with a future value
equal to $337,733.50 in your account:

<Fitri Santi, SE, M.Si>

A Ferrari, Please?
Suppose you would like to put away enough money to buy a
nice $68,000 Ferrari for your tenth reunion in 153 months
(12 years from May). You earn interest on your savings
account at a rate of 6% compounded monthly.
Will you be able to afford the car if you save $300 every
month?
Solution
You will have the future value of an annuity with $300
payments each month for 153 months with an annual rate of
6% interest compounded monthly (i.e., 0.5% per month):

Yes, you can afford it!

<Fitri Santi, SE, M.Si>

• Fred McHuman’s Publisher’s Outhouse
• Fred McHuman of Publisher’s Outhouse
announced you have just won $30,000,000.
This money is to be paid in $1,000,000
installments at the end of each of the next 30
years. If the appropriate discount rate is
7.5%, what are the winnings really worth to
you?
• Solution: Not as much as it sounds:

<Fitri Santi, SE, M.Si>

Compounding More Than Once
Whereas simple interest is the interest paid only on the initial
investment, compound interest reinvests each interest payment on the
money invested.
For example, consider the case when $100 is invested for two years at
10%. At the end of the first year, the amount grows to $110 because an
interest of $10 is paid at the time on $100. At the end of the next
year, however, the amount grows to $121 because $10 interest is paid
on the initial $100 and, in addition, a $1 interest is paid on the $10
reinvested at the end of year 1.
If only simple interest was paid, it would still be $10 at the end of the
second year, giving us a future value of $120 as opposed to $121 with
compounding.
What is the effect of compounding two times during the same year? Or
four times, i.e., each quarter?
Intuitively, the money should grow faster.
Consider, for example, an annual interest rate of 10% compounded four
times, i.e., an interest rate of 2.5% paid every quarter, instead of an
interest rate of 10% paid every year.
In this case after one year $1 becomes 1 x (1 + 0.025)4 = 1.1038
Therefore, the effective annual interest rate is 10.38% instead of 10%.

<Fitri Santi, SE, M.Si>

• In general, if i is the rate/period and compounding
takes place m times a year, then the present value of a
cash flow PMT occurring at n is given by:

• In the case when m is allowed to become large, your

initial investment is compounded extremely frequently.
As m approaches infinity, the investment is said to be
continuously compounded and its present value is:

• The exponential function ex, a value 2.718282 when x

= 1, has value 0.367879 when x = -1, and so on, growing
as well as decaying “exponentially.”

<Fitri Santi, SE, M.Si>

Example
Suppose you invest $200 at 12% continuously compounded for
two years. What do you receive at the end of two years? We
know i.n = 0.12 x 2 = 0.24 giving e0.24 = 1.271.
Therefore, the future value of $200 invested today is given by
PMT = 200 x 1.271 = $254.20.
A Work Training Example
Suppose you propose to bartend at a local restaurant five nights
a week. You expect to save $125 a month from the job after
meeting your expenses. To be eligible for the job you must
undergo a week’s work training at the restaurant. Suppose you
plan to work the next nine months at the restaurant and you can
borrow and lend money at an annual rate of 6% compounded
monthly. What is the present value of the training to you?
Solution
The monthly interest rate is 0.5%. You will save $125 at the end
of each month.

= $1097.38.

<Fitri Santi, SE, M.Si>

Effective Annual Rate
Suppose i denotes the continuously compounded rate and ia denotes
the effective annual rate. Then, given i can we find ia?
Remember that $1 invested today at i becomes C1 = ei at the end
of the year. Hence, ia must be a rate such that $1 growing at a
simple rate becomes PMT in one year, i.e., PMT = (1 + ia). Equating
the two expressions gives us:
Example
If the continuously compounded rate i = 10%, what is the effective
annual rate ia ? We can write ia = e0.10 - 1 = 1.105 - 1 = 0.105 or
10.5%.
Another Example
Consider the following advertisement in the paper.
Explain the difference between the yield and the rate:

<Fitri Santi, SE, M.Si>

• The annual interest rate is 8.55%. However, it is being
compounded during the year. The result is a higher
effective interest rate of 8.82% which is being referred
to as yield. Can we estimate how many times the rate of
8.55% is being compounded?
• First, notice that if we invest a dollar at 8.82%, it
becomes $1.0882 in one year. Next, if we compound
8.55% two times what do we get? Three times? Four
times? When does our dollar equal $1.0882?
• The following equation states this relation:

• We want to compound 8.55% sufficient number of times

to make it yield 8.82%. The answer is 4; therefore, 8.55%
must be compounded quarterly, i.e., each quarter we get
paid 2.1375% and the interest is reinvested on our
behalf.

<Fitri Santi, SE, M.Si>

One More Example
• You see the following ad in the paper.

• The car you propose to buy is worth $11,000. What will be

your monthly car payments?
• At 4.8% annual rate, you pay 0.4% (4.8/12) interest each
month.
• Suppose you pay PMT each month. Then the present value of
the payments must equal the present value of the car, i.e.,
$11,000.
• Therefore, the following relation must hold:

<Fitri Santi, SE, M.Si>

Solving the equation gives PMT = $252.33. How can we
determine the present value of the monthly car payments of
$252.33 to you?
Notice that this may not equal $11,000.
Suppose you currently invest in a money market account earning
8% effective annual rate. Therefore, your opportunity cost of
capital is given by what you make on the money market account.
Your monthly opportunity cost im can be obtained by solving
(1 + im)12 = 1.08  im = (1.08)1/12 - 1 = 0.6434%.
This means that we can write the present value of the car
payments to you by discounting your monthly car payment by
0.6434%:

Therefore, the present value of the car payments to you is

$10,391.48. What does it mean? This means that you can invest
$10,391.48 in your money market account today, and get monthly
payments of $252.33 from it and make your car payments.
Alternatively, you will be willing to settle for a cash discount of
any number over $608.52. Why?

<Fitri Santi, SE, M.Si>

 A Loan Amortization Example
Consider a loan of $6000 at 15% interest rate which is to be
repaid in four equal installments at the end of each year. What is
the annual payment of the loan? Construct an amortization
schedule for the loan.
Solution
$6000 = PMT×PVIFA15%, 4yrs, i.e., $6000 = PMT× 2.855 from
the annuity tables. Therefore, PMT = $2101.58.
The amortization schedule gives the breakup of each loan payment
into interest and principal components. It also shows the balance
(principal) payment at the end of each period over the life of the
loan. In our case, we have:

<Fitri Santi, SE, M.Si>

An Example with Infinitely Many Unequal Flows
As a cemetery manager, you are considering offering perpetual care
contracts. You estimate that maintenance will cost you $500 during
each of the first five years and $200 every year thereafter. If the
appropriate discount rate is 5.5%, how much do you need to charge
to break even on a perpetual care contract?
Solution
The cash flows in this example are a combination of an annuity and a
perpetuity with the following cash flows:

Therefore, the present value is:

Therefore, you need to charge $4917.45 to break even.

<Fitri Santi, SE, M.Si>

 An Example of Finite Unequal Cash Flows
• Publisher’s Clearing House promises to pay you $500,000 in
one year, $250,000 at the end of each of the following 28
years and $2,500,000 at the end of 30 years. What is this
prize’s value today given i = 7% compounded yearly?

• Solution
• The cash flows from the winnings are as follows:

• Therefore, you get $250,000 in year 1:

<Fitri Santi, SE, M.Si>

 In addition, you get $250,000 for 29 years:

Also, you get $2,500,000 in year 30:

This gives us a total of:

$233,645 + $3,069,419 + $328,418 =$3,631,481.
This is the prize value at i = 7%.

<Fitri Santi, SE, M.Si>

Finish

<Fitri Santi, SE, M.Si>